Early this month, JPMorgan Chase & Co. stopped managing an investment account for a prominent client: the charitable foundation of Sigma Alpha Epsilon, one of the nation’s largest fraternities.

The bank was concerned about SAE’s bad publicity, according to Anthony Alberico, a JPMorgan vice president who dealt with the foundation. SAE has had 10 deaths linked to drinking, drugs and hazing since 2006, more than any other fraternity.

The snub by the largest U.S. bank validated a startling decision that Cohen, seeking to protect future members, had already reached. On March 7, the same day JPMorgan formally cut ties with the fraternity, the 51-year-old Cohen announced an end to one of SAE’s defining traditions: pledging, the months-long initiation where recruits sometimes fall prey to brutal hazing. The move catapulted Cohen into national prominence and drew criticism from alumni such as Texas oilman-turned-investor T. Boone Pickens. SAE became one of only a handful of 75 national fraternities to eliminate pledging.

“How much longer can we sustain these losses — loss of life, loss of credibility to those who join and drop out because they were lied to, loss of valuable resources and loss of our reputation as leaders and as true gentlemen,” Cohen told SAE brothers this month at the University of La Verne in California during his first public address since the announcement.

Secret Handshake

Cohen, who took office only nine months ago, faced intense pressure to change the culture of SAE, according to him and other top fraternity officials. Besides JPMorgan, Lloyd’s of London was threatening to cancel SAE’s insurance coverage because of injuries, deaths and lawsuits.

Family considerations also motivated Cohen. He wanted to protect his older son, Devon, a high school freshman who is determined to join SAE in college. Devon wears bow ties in purple and gold — SAE’s colors — and knows its secret handshake.

“I don’t want him to be scarred mentally from hazing,” said Brad Cohen, relaxing with his family in their home near Los Angeles. “I don’t want him to want to join SAE so badly that he’ll do anything he’s told.”

Backlash Stirred

Cohen’s pledging ban has stirred a backlash from some student and alumni members of SAE, which was founded at the University of Alabama in 1856 and has more than 240 chapters and 14,000 college members. Cohen, who must step down at the end of his term next year, took the chance that traditionalists could unseat his allies on the board at the fraternity’s next convention in 2015, he said.

Renowned as a Wall Street pipeline, SAE boasts prominent alumni such as hedge fund managers David Einhorn of Greenlight Capital and Paul Tudor Jones of Tudor Investment Corp. Pickens, whom Cohen consulted before announcing the pledging ban, said through a spokesman that he has reservations about it.

“Mr. Pickens believes pledgeship is a key part of fraternity life and helps those who go through it gain an appreciation for the rich history tied to each fraternity,” spokesman Jay Rosser said in an e-mail. Pickens supports a “greater focus” on alcohol and drug awareness, Rosser said.

“Either way, he appreciates the tough choice Brad Cohen has made,” Rosser said. “Time will tell if it was a good one.”

SAE chapters will still extend recruits a “bid,” or invitation to join. But students who accept will become full members almost immediately. They will be required to complete additional training, including alcohol education.

‘Insta-Bros.’

Angry student members are deriding those inducted immediately into the order as “insta-bros.” They also question whether the SAE board has authority under its bylaws, as Cohen maintains, to impose the ban on local chapters. Their posts warning that brotherly bonds will fade or pledging will go underground pack a Facebook page called “SAE Cause for Change.”

People need to face adversity in order to feel accomplished

“Doing away with the pledge program is like giving all the kids on a youth soccer team trophies at the end of the season for doing ‘a good job,’” one critic wrote. “People need to face adversity in order to feel accomplished.”

E-mails and phone messages praising Cohen’s move poured in from administrators, fraternity members and families affected by hazing.

‘Brave Leader’

“We feel like he’s a strong, brave leader for taking this organization forward,” said Scott Starkey, who called Cohen to applaud the decision. Starkey’s son, Carson, died of alcohol poisoning in 2008 as a freshman during an SAE hazing at California Polytechnic State University in San Luis Obispo.

The son of an Olympic athlete, the 6-foot-1-inch Cohen has a square jaw and a commanding presence. Owner and chief executive officer of a real estate company based in Newport Beach, California, he has spent almost 30 years in volunteer leadership roles at SAE. His brother and nephew belong to the order, and his father was an honorary member. Cohen counts his induction into SAE among the most meaningful ceremonies of his life, along with his wedding and the naming of his three children. SAE awards cover the walls in his study.

He tries to live by SAE’s “perfect” creed, the “True Gentleman,” which all members must memorize, he said. It is a kind of golden rule of fraternity life, which begins: “The true gentleman is the man whose conduct proceeds from good will and an acute sense of propriety, and whose self-control is equal to all emergencies.”

Unusual Background

In many ways, Cohen has an unusual background for an SAE leader. He’s the first Jewish president of SAE, which used to limit membership to “members of the Caucasian race” without a parent who was a “full-blooded Jew,” according to a 1903 book of rituals.

Holding the black volume aloft, Cohen read that passage to his audience at the University of La Verne. When SAE renounced racism and anti-Semitism in 1952, he reminded the crowd, it faced the same complaints that change would ruin the fraternity that traditionalists now make about the pledging ban.

A Type 1 diabetic diagnosed at age 11, Cohen abhors forced drinking, which is often part of fraternity hazing. He worries that alcohol consumption, which can wreak havoc on a diabetic’s blood-sugar levels, endangers students with all kinds of health issues. Cohen, who wears an insulin pump, serves on the executive board of the University of California at Irvine diabetes research center. His son, Devon, also has the disease and held a diabetes fundraiser for his bar mitzvah in 2012.

South Africa

Cohen is also SAE’s first foreign-born leader, and speaks in the lilting accent of his native South Africa. His late father, Desmond Vernon Cohen, was an obstetrician-gynecologist, as well as a swimmer and water polo player on two South African Olympic teams.

Fearing racial strife over the government’s apartheid policy, the family left South Africa in the late 1970s when Cohen was 16. When he announced the pledging ban, Cohen compared the treatment of new members as “second-class citizens” to the abuse of blacks under apartheid.

Feeling lost and alone as a foreign student at the University of Arizona, Cohen helped alumni reopen the SAE chapter there. It had been shut down years before for hazing, including branding pledges on their buttocks with “Phi Alpha,” the SAE salutation and motto, Cohen said.

Leopard Print

While Cohen’s pledging didn’t include physical hazing, he was subjected to practical jokes, such as taking a fake national exam, he said. Once initiated, he made lifelong friends. In his study, he flips through old photos of himself with his fraternity buddies, including one at a party where he is dressed as a Zulu warrior, in a scanty leopard-print outfit.

After graduating from Arizona with a bachelor’s in psychology and business administration in 1985, Cohen worked for two years at SAE’s headquarters in Evanston, Illinois. As director of expansion, he helped establish more than 20 new chapters, including one at Yale University in New Haven, Connecticut.

Cohen moved to Southern California in 1988. After a stint at Xerox Corp., he started working in the title insurance business. In 2009, he opened his own company, Granite Escrow Services Inc., which has annual revenue of more than $10 million, almost 100 employees and seven offices.

By then, Cohen had joined the Supreme Council, SAE’s governing board. He was also increasingly dismayed by hazing- related tragedies, including Starkey’s death after downing beer, rum and 151-proof liquor in an initiation ritual.

His wife, Kim, a former singer and actress who is also from South Africa, shared his concerns. Devon and their younger son, Zachary, wouldn’t have been allowed to join certain SAE chapters before pledging was eliminated, she said. “As a mother, I would have been scared to put them in an environment like that.”

As Cohen rose through SAE’s ranks, he pushed for a more comprehensive safety program, called “Minerva’s Shield,” which includes rules about alcohol and sexual consent, as well as a prohibition on hazing. It was adopted in 2004.

Still, universities have disciplined more than 100 SAE chapters since 2007, some repeatedly, according to a list published on the organization’s website as a result of a legal settlement. Colleges suspended or closed at least 15 SAE chapters in the past three years. In 2011, a sophomore pre- medical student at Cornell University died from alcohol poisoning after being blindfolded by SAE pledges in an initiation ritual.

Supreme Archon

Last June, when Cohen became president — or officially, Eminent Supreme Archon — he signaled his commitment to significant change by backing a proposal to ban alcohol in chapter houses. At the convention in Chicago, it failed to get the two-thirds vote needed to pass.

Cohen settled for a symbolic step. The council told chapters to stop using the word pledge and refer to recruits simply as “new members.” The goal was that they would be treated more humanely.

Cohen should have continued to focus his fight on alcohol abuse, said Nicholas Syrett, an associate professor at the University of Northern Colorado and author of a book about the history of fraternities. Ending pledging “doesn’t seem like it will change anything about the binge drinking at parties that doesn’t have anything to do with pledging,” Syrett said.

How many more new members have to die before everyone is willing to change the way we operate?

Insurance Risk

As deaths and injuries mounted, Lloyd’s of London became increasingly concerned about the risk of insuring SAE. It threatened to drop coverage because the fraternity poses too great a risk, according to Gregory Brandt, a state judge in Iowa, and Steven Churchill, executive director of the American Medical Association, both SAE council members. Loss of coverage could shut down SAE, they said.

The Lloyd’s warning was a turning point that “changed the way” SAE officials viewed the fraternity’s “future viability,” Churchill said.

Members already pay a base fee of $340 a year for liability coverage, among the highest rates of any fraternity. The SAE national’s deductible is $1.5 million a year, Cohen said.

Media pressure on SAE also mounted. A December Bloomberg News article, which called SAE the “deadliest fraternity,” revealed previously unreported hazing at Salisbury University in Maryland.

German Rock

During an eight-week initiation in 2012, SAE brothers at Salisbury forced pledges to drink until they almost passed out and demanded they recite the True Gentleman pledge wearing only their underwear while standing in trash cans filled with ice, Bloomberg reported.

Fraternity members confined recruits for as long as nine hours in a dark basement without food, water or a bathroom, while blasting the same German rock song at ear-splitting volume, according to two former pledges and the findings of the university’s disciplinary board.

In the wake of the Bloomberg article, Cohen asked Dwight “Duke” Marshall, the volunteer alumni adviser for SAE’s Salisbury chapter, about what happened in the basement. Marshall said brothers had played the music only to prevent pledges from hearing secret SAE rituals taking place upstairs, according to Cohen.

Cohen fired off an e-mail to Marshall and other alumni that likened confining students in the dark, amid deafening German music, to something out of Auschwitz, the Nazi death camp.

Taking Offense

“I take offense to that as a Jew,” he remembered saying in the e-mail. “I take offense as a member of SAE.”

Marshall and others downplayed the seriousness of hazing at Salisbury to the national fraternity, Cohen said. On Feb. 2, SAE suspended the chapter’s charter and said brothers will lose membership privileges. The university has suspended the chapter through the summer of 2015.

In an interview this week, Marshall said he didn’t mislead Cohen and found his e-mail offensive. Still, he said he respects Cohen’s opinion. “He’s our leader,” he said.

Cohen and the rest of the Supreme Council began considering a pledging ban. At a Jan. 19 meeting in Tucson, Arizona, they debated the idea and alternatives such as shortening the initiation period.

The final decision to stop pledging came on a Feb. 3 conference call. Cohen said the council kept its plan under wraps for fear that hazers would accelerate abuse of pledges before the program was eliminated.

“How many more new members have to die before everyone is willing to change the way we operate?” SAE Executive Director Blaine Ayers said in an e-mail.

Bank’s Rebuff

A rebuff from an unexpected quarter reaffirmed the council’s resolve. SAE’s charitable foundation had an investment account with New York-based JPMorgan containing about $500,000, which was primarily used to make payments on a loan and occasionally to sell stock gifts. The account dated back to the mid-2000’s, Cohen said.

Then, in February, JPMorgan said that it was reconsidering the relationship to avoid tarnishing its reputation, according to Todd Buchanan, vice president of the foundation and one of Cohen’s predecessors as SAE’s leader.

“It was shocking,” Buchanan said. “It really spoke to why we needed to make a stand. We’re better than this.”

The bank, which has said it would pay more than $23 billion to resolve regulatory and criminal investigations, has cut ties since last year with about 2,000 clients that could attract scrutiny, according to a person with knowledge of the matter. Emily Sackett, a JPMorgan spokeswoman, declined to comment.

Terminated Ties

Cohen and Buchanan said they learned March 6 that JPMorgan had decided to quit doing business with SAE’s foundation. On March 7, the bank sent a letter terminating the relationship. That day, Cohen announced the pledging ban.

“As an organization, we have been plagued with too much bad behavior, which has resulted in loss of lives, negative press and large lawsuits,” he said in a video address.

A week later, during a student leadership conference at the University of La Verne, Cohen milled around with undergraduates from chapters across Southern California. Some admired his purple and gold tie, adorned with tiny phoenixes.

“We’re like the Phoenix,” Cohen told them. “We’re rising from the ashes.”

Filing into the arena under a huge American flag, SAE brothers wore khakis, blazers and crisp white shirts, and ties in the fraternity’s colors. Sorority women in high heels acted as hostesses.

‘Guiding Light’

The brothers shouted the SAE motto, “Phi Alpha,” before joining in a medley of fraternity songs, filling the arena with rich baritones: “And to Phi Alpha with its guiding light, And to the lion who will fight, fight, fight.”

For half an hour, Cohen made his case that the Supreme Council had no choice but to ban pledging:

“No parent should ever have to suffer the loss of a child because that child was simply trying to join a fraternity — our beloved fraternity, where we claim to be true gentlemen.”

After the speech, Alexi Sciutto, who just graduated from California State University at Northridge, buttonholed Cohen to offer support. His SAE brothers helped him cope with his mother’s death from breast cancer, he said.

“I’ll do whatever needs to be done to keep SAE alive,” he told Cohen. “And I’ll do it until I die.”

Christian Couch, 21, a junior from California State University at Long Beach who attended Cohen’s speech, said he disagreed with the new policy.

‘Easy Out’

“It doesn’t feel right. You just sign up and you’re automatically in,” he said. “It’s the easy way out.”

After the speech, Cohen joined other fraternity staff and volunteers in workshops about the revamped program for new members, called “The True Gentleman Experience.”

Leaning against a wall in a classroom with 25 SAE members, Cohen said that brothers must still learn rituals, including the SAE creed. “They don’t need to learn the True Gentleman standing in a tub of ice, half naked,” he said.

Back in Cohen’s family room, his 14-year-old son, Devon, said he’s pleased that SAE eliminated pledging. His parents support his ambition to join the fraternity.

Wall Street faces more intensive government scrutiny of trading after U.S. regulators issued what they billed as a strict Volcker rule today, imposing new curbs designed to prevent financial blowups while leaving many details to be worked out later.

The Federal Reserve, Federal Deposit Insurance Corp. and three other agencies planned by the end of the day to complete formal adoption of the proprietary trading ban, which has been contested by JPMorgan Chase & Co., Goldman Sachs Group Inc. and their industry allies for more than three years.

Wall Street’s lobbying efforts paid off in easing some provisions of the rule. Regulators granted a broader exemption for banks’ market-making desks, on the condition that traders aren’t paid in a way that rewards proprietary trading. The regulation also exempts some securities tied to foreign sovereign debt.

At the same time, regulators said the final version imposed stricter restrictions on hedging, providing banks less leeway for classifying bets as broad hedges for other risks. To pursue a hedge, banks would need to provide detailed and updated information for review by on-site bank supervisors.

Related

“This provision of the Dodd-Frank Act has the important objective of limiting excessive risk-taking by depository institutions and their affiliates,” Fed Chairman Ben S. Bernanke said in a statement. “The ultimate effectiveness of the rule will depend importantly on supervisors, who will need to find the appropriate balance while providing feedback to the board on how the rule works in practice.”

The Fed gave banks a delay until July 21, 2015 to comply with the rule. Beginning June 30, 2014, banks with $50 billion in consolidated assets and liabilities must report quantitative information about their trading.

The rule is named for Paul Volcker, the former Fed chairman credited with taming rampant inflation in the 1970s and who served as a top adviser to President Barack Obama. Volcker, 86, proposed the ban as a means of restoring stability to Wall Street following the 2008 financial crisis, arguing that banks that benefit from federal deposit insurance and discount borrowing shouldn’t be permitted to take risks that could trigger a taxpayer-funded government bailout.

The rule, enshrined by the Dodd-Frank Act of 2010, allows exemptions for market-making and some hedging, and defines limits for banks’ investments in private equity and hedge funds. The version issued today is 71 pages long, with an additional 850-page preamble.

“This rule is so complex and massive that it is essential that the regulators not conflate inadvertent mistakes with purposeful violations,” H. Rodgin Cohen, senior chairman of the Sullivan & Cromwell LLP law firm, which represents Wall Street banks, said in an e-mailed statement.

With Wall Street banks having already shut proprietary trading desks in anticipation of the rule, its remaining impact rests largely in the fine print — how regulators will conduct oversight of other banking activities, primarily market-making and hedging.

Wall Street’s five largest firms had as much as $44 billion in revenue at stake on the outcome of just the market-making provision, according to data for the year ended Sept. 30. JPMorgan, the biggest U.S. lender by assets, had as much as $11.4 billion riding on the answer.

The rule by the Fed, FDIC, Securities and Exchange Commission, Commodity Futures Trading Commission and Office of the Comptroller of the Currency sets parameters for how banks may buy and sell financial products for clients and manage their own risks in the process.

Business groups have signaled that they may challenge the rule in court.

“We will now have to carefully examine the final rule to consider the impact on liquidity and market-making, and take all options into account as we decide how best to proceed,” David Hirschmann, president of the U.S. Chamber of Commerce’s Center for Capital Markets Competitiveness.

Here are summaries of the rule’s major provisions:

Making Markets

The Volcker rule bans banks including New York-based Goldman Sachs and Morgan Stanley from trading to profit for their own accounts, while allowing them to continue making markets for clients. Distinguishing between those two practices has been one of the most difficult tasks for regulators.

In the final rule, regulators eased the criteria banks must meet to qualify for the market-making exemption. To receive the exemption, a trading desk must both buy and sell contracts or enter into both long and short positions of those instruments for its own account.

The trades must not exceed, on an ongoing basis, the “reasonably expected near-term demands of clients.” The rule instructs banks to determine that demand based on historical data and other market factors. Further, the rule requires that compensation arrangements not be designed to reward prohibited trading.

Fed Governor Daniel Tarullo said the rule had been “simplified somewhat, particularly by reducing the number of metrics that will be used in the reporting and analysis of trading data.”

Industry lobbyists urged the exemption be widened, saying regulators needed to recognize that banks routinely buy and sell stocks, bonds and derivatives and build up inventories to help clients when they eventually place orders. Banks were joined by asset managers such as Vanguard Group Inc. and AllianceBernstein Holding LP in warning that a narrow exemption could unsettle markets.

Portfolio Hedging

In the final rule, regulators required banks to demonstrate on an ongoing basis that their trades hedge specific risks in order to win an exemption from the Volcker rule.

The banks must analyze and independently test that a hedge “demonstrably reduces or otherwise significantly mitigates one or more specific, identifiable risks,” the rule said.

The final rule requires banks to have an “ongoing recalibration of the hedging activity by the banking entity to ensure that the hedging activity” is not prohibited.

The hedging provision became central to the Volcker rule debate after JPMorgan lost $6.2 billion last year in bets on credit derivatives known as the London Whale. The trades, conducted in the U.K. by the bank’s chief investment office and nicknamed for their market impact, were described by JPMorgan executives as a portfolio hedge. The bank’s synthetic credit portfolio produced about $2.5 billion of revenue in the five years before 2012, according to a Senate subcommittee report on the bets.

Bart Chilton, a Democratic CFTC commissioner who earlier said he planned to vote against the rule because it was too weak, said today that it had been strengthened enough to win his support.

“The language has been solidified tightly to avoid loopholes,” Chilton said in a statement. “When people say this version of the Volcker rule will stop circumstances like the London Whale, this ongoing recalibration provision is exactly what will help avoid similar debacles.”

Senator Carl Levin, 79, the Michigan Democrat who leads the Permanent Subcommittee on Investigations, joined other Democrats and some regulators in pushing for a narrow definition of hedging after the JPMorgan trades.

Three months after the losses were disclosed in 2012, JPMorgan Chairman and Chief Executive Officer Jamie Dimon, 57, told lawmakers that the Volcker ban “may very well have stopped parts of what this portfolio morphed into.”

Sovereign Debt

The buying and selling of securities backed by a foreign sovereign will not fall under the proprietary trading ban in most circumstances, according to the rule. That exemption includes securities issued by foreign central banks and applies to U.S. banks with overseas operations as well as foreign firms with affiliates in the U.S.

The initial Volcker rule draft drew international criticism for its reach into banks based overseas as well as for its impact on foreign sovereign debt markets.

Michel Barnier, the European Union’s financial services chief, complained about the rule’s “extraterritorial consequences.” Canadian and Mexican bankers and government officials said the proprietary trading ban would violate the North American Free Trade Agreement’s guarantee that banks be allowed to deal equally in U.S. and Canadian debt obligations.

Regulators also allowed more flexibility for overseas banks. They will be exempt from the ban for trades accounted for outside the U.S. so long as their employees deciding to buy and sell contracts are also located outside the country. The final rule also frees overseas banks from the ban for trades they conduct on U.S.-based exchanges and clearinghouses, and for trades they have with foreign operations of U.S. banks.

Fund Investments

The proprietary trading rule seeks to limit banks’ speculative bets in another way: by curbing their investments in private equity, hedge funds and commodity pools.

U.S. banks have already begun cutting their stakes in such funds, and will need to reduce them further to meet the law’s limit of 3 percent of Tier 1 capital invested in the funds. For example, Goldman Sachs cut its investment in such funds to $14.9 billion as of Sept. 30, down from $15.4 billion when Dodd-Frank was passed.

Regulators granted broader exemptions for some types of funds. Under the final rule, joint ventures, issuers of asset- backed securities and wholly-owned subsidiaries are among exempt funds.

CEO Responsibility

Apart from the specific limits on bank investments and trading practices, the Volcker rule includes efforts to change the culture of trading on Wall Street.

Toward that end, the rule tells banks’ boards and top managers that they “are responsible for setting and communicating an appropriate culture of compliance.”

The centerpiece of the governance changes is a requirement that CEOs “annually attest in writing” that the company has “procedures to establish, maintain, enforce, review, test and modify” the compliance program.

The wording will be a relief to Wall Street chiefs who were concerned that they would have to personally guarantee that their firms were in compliance with the rule, according to people familiar with the banks’ thinking. Executives already file a similar certification with the Financial Industry Regulatory Authority, a self-regulatory group for brokerage firms.

The certification wasn’t part of the Volcker rule when it was first proposed two years ago; it was added to send a signal that regulators weren’t bending to a massive lobbying campaign by financial firms, according to two officials familiar with the rule.

Supervisory Focus

In the end, after hundreds of pages outlining numerous what-if’s, exemptions and special circumstances, the rule reiterates that banks will now have to prove to supervisors that they are adhering to the overriding principle that Volcker and Obama put forward in 2010 as a way to prevent another financial meltdown.

According to documents released by the Fed, the rule prohibits “any transaction or activity” exposing banks to high-risk assets or strategies “that would substantially increase the likelihood that the banking entity would incur a substantial financial loss or would pose a threat to the financial stability of the United States.”

]]>http://business.financialpost.com/investing/volcker-rule-heres-how-the-final-version-will-look/feed0stdWall StreetWhy you should be buying U.S. financials right nowhttp://business.financialpost.com/investing/trading-desk/why-you-should-be-buying-u-s-financials-right-now
http://business.financialpost.com/investing/trading-desk/why-you-should-be-buying-u-s-financials-right-now#commentsMon, 28 Oct 2013 16:22:29 +0000http://business.financialpost.com/?p=380677

The relationship between financials and U.S. stocks has broken down, as the sector has underperformed the broader market on concerns about declining mortgage applications and the resulting contraction in loan growth.

Acknowledging that housing activity plays a crucial role in the operating performance of financials, BMO Capital Markets chief investment strategist Brian Belski also noted longer-term trends in other market indicators suggest things are still headed in the right direction for the residential real estate.

As a result, he told clients to use the recent weakness in financials as an opportunity to increase exposure and reiterated his overweight recommendation.

“Based on historical data, strong market environments are typically categorized by even stronger performance from financials,” Mr. Belski said. “This isn’t too surprising since it has been one of the largest S&P 500 sectors in terms of both market capitalization and earnings contribution through the years.”

His analysis of the rolling one-year periods for the S&P 500 and financials since 1970 paints a compelling case.

In all periods where the S&P 500 return was 10% or greater, the average return for financials was 26%.

Financials outperformed in roughly 63% of the periods when S&P 500 performance was 10% or greater.

The return for financials was negative in less than 4% of the periods when S&P 500 performance was 10% or greater.

However, the strategist also cautioned that any prolonged period of underperformance for financials could be the canary in the coal mine for this bull market. He highlighted other figures to support this thesis.

In all periods where financials underperformed the market, the average return for the S&P 500 was below average at roughly 7%.

In all periods where financials’ performance was relatively flat, the average return of the S&P 500 was about -2%. Also, S&P 500 returns were negative in 40% of these periods and only produced double-digit gains 20% of the time.

In all periods where financials produced negative returns, the average return of the S&P 500 was -9%.

“From our perspective, the financial crisis resulted in a high level of fear and mistrust of financial markets from individual investors,” Mr. Belski said.

The strategist believes those fears will only be eased when investors understand process, discipline and advice, something that can be provided by a trusted relationship with a private wealth management advisor.

“That ‘advice’ will ultimately mean more transactions at some point, precisely the type of lower margin but steady business that we believe will provide a primary growth engine for the sector for the next several years,” he said.

He highlighted Ameriprise Financial Inc., Bank of America Corp., The Bank of New York Mellon Corp., IVZ Invesco Ltd., J.P. Morgan Chase & Co., Morgan Stanley and State Street Corp. as the best options.

A series of derailments at Canadian Pacific Railway Ltd. is expected to drag on the company’s earnings during the second quarter.

The railroad has had six accidents and derailments in recent months, including four during the current quarter.

The latest occured last Sunday when an intermodal train derailed in Northern Ontario, damaging a trestle bridge and spilling several containers in the river below. Two containers remained in the water as of late Thursday.

Related

Thomas Wadewitz, JPMorgan analyst, said he didn’t expect much of an impact from the first three incidents during the second quarter, but that the latest one, outside of Sudbury, Ont., would likely be more costly for the railroad.

Several union leaders have raised concerns that the dramatic restructuring underway at the railway may be contributing to the accidents. But Mr. Wadewtiz said he didn’t agree at this point.

“The accidents that CP has experienced over the past several months have been due to a variety of factors including wheel failures, track issues and human error,” he said in a note to clients. “We will watch carefully to see if a pattern develops but at this point we do not believe that the derailments point to any broader issue.”

Mr. Wadewitz estimates the latest derailment will cost railway roughly $10-million during the quarter, adding to the $10-million to $15-million in expenses from the other three.

As a result, he said he was lowering his earnings forecast for the railway in the second quarter from $1.67 a share to $1.60 a share. He noted his estimate was still well ahead of analysts’ consensus of $1.52 a share in the second quarter.

Mr. Wadewitz said while the derailments will take away some of the potential upside at the railway, he still expects the second quarter results to reflect the changes underway and the upside potential of the stock.

He has a $153 a share price target for the railway and an overweight rating on the stock.

]]>http://business.financialpost.com/investing/trading-desk/cp-rail-accidents-expected-to-cost-up-to-25m/feed0stdCP RailTerence Corcoran: Big business is the new un-American activityhttp://business.financialpost.com/fp-comment/terence-corcoran-the-new-un-american-activity
http://business.financialpost.com/fp-comment/terence-corcoran-the-new-un-american-activity#commentsWed, 22 May 2013 03:20:40 +0000http://opinion.financialpost.com/?p=28266

With the attacks on JPMorgan’s Jamie Dimon and Apple’s Tim Cook, the U.S. left has settled in on a new definition of un-American activity: big business.

A Wall Street Journal story over the weekend reports on a fresh batch of Hollywood movies that take aim at big business. Opening May 31, for example, is The East, described as a thriller about an underground activist collective, including stars Alexander Skarsgard and Ellen Page, that creates an oil spill inside the home of an oil-company CEO and makes drug-company executives taste the ruinous side effects of their own medicine.

The director and co-writer of this latest in a series of Occupy-inspired films, Zal Batmanglij, said: “Our goal wasn’t to make the CEO a bad guy. That’s easy and silly.” How true, especially these days when juvenile horse-whipping of big business and corporate CEOs is routine at the highest echelons of American politics and culture. Who needs low-down pop-entertainers and cheap movies to portray business executives as thugs and crooks when politicians, unions and other leftists garner headlines doing exactly that on a daily basis.

In Tampa Tuesday, Jamie Dimon — chairman and CEO of JP Morgan, America’s most successful bank enterprise —s urvived a shareholder vote orchestrated by union pension funds to curb his power. The objective, under cover of so-called corporate governance principles, was to strip Mr. Morgan of some of his responsibilities by splitting the role of chairman and CEO. The activists lost the vote, but not before turning JPMorgan and Mr. Dimon into paragons of corporate bloat and incompetence.

The shareholder revolt fizzled at JPMorgan, but it is another in a long line of attacks on bankers and other members of the U.S. corporate establishment.

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Big business is becoming the new un-American activity. That prospect came to mind Tuesday when Tim Cook, the CEO of Apple, one of the most phenomenal free-market enterprises in world history, was hauled before a Senate sub-committee to defend Apple’s record as a tax-paying corporation. Leading an attack as if he were probing for subversive behavior, Democratic Senator Carl Levin portrayed Apple as a loophole-seeker that was leeching the American public by not paying tax on money earned outside the United States. “We intend to highlight that gimmick and other Apple offshore tax avoidance tactics so that American working families who pay their share of taxes understand how offshore tax loopholes raise their tax burden, add to the federal deficit and ought to be closed,” said Levin.

At one point he described Apple’s tax structure as a “sham,” to which Mr. Cook replied: “I don’t consider deferral to be a sham.” That’s a good line, likely lost on the millions of Americans who are being hoodwinked by Congressional activists and others who don’t know what tax deferrals are — and don’t want to know.

Otherwise the interrogation of Mr. Cook followed the familiar Congressional inquisitional pattern. The result was instant TV images of a corporate CEO being held to account by blustering politicians that make Saturday Night Live’s parodies of Congressional hearings look like reasonable proxies for the real thing.

The underlying gist of the Congressional probe of Apple’s tax record is that corporate profits belong to the government and would serve the economy better if more of them were seized as taxes. Apple may already be the largest corporate taxpayer in America, accounting for $1 out of every $40 in corporate tax collected. That’s not enough for some Senators, including John McCain, who semi-wittily countered that “by sheer size and scale, [Apple] is also among America’s largest tax avoiders.”

As Mr. McCain knows, tax avoidance is perfectly legal and totally justified. Apple holds billions in undistributed income in Ireland and elsewhere, money that allows the company to expand and grow. If Apple failed to take advantage of existing tax codes—which exist to promote foreign expansion of U.S. businesses – it would be derelict in its management of taxes.

The political attacks on corporate tax behaviour are part of a concerted global effort by governments everywhere to raise taxes. At least the United States has one whistleblower on this inside job. Sen. Ron Paul called the Levin proceedings a “show trial.” He called for lower corporate tax rates. “If anyone should be on trial here, it should be Congress.”

For Wall Street and Apple shareholders — and shareholders everywhere — Mr. Cook performed heroically before Congress. So did Mr. Dimon before shareholders. Only 32% voted to split his role at JPMorgan, a poor return given the big name union/government pension plans that backed the governance proposal.

One of the pretexts for going after JPMorgan’s executive structure was a $6.2-billion trading loss last year known as the London Whale fiasco. The same Sen. Levin who interrogated Mr. Cook Tuesday treated Mr. Dimon as a corporate criminal for having allowed the trade loss.

Shareholders clearly feel differently. JPMorgan reported its largest profit in history last year and the company’s stock has gained 56% since the London Whale was first reported.

Not all media have been sucked into the anti-corporate campaigns. Matthew Yglesias, Slate’s business writer, said Tuesday there’s nothing new in the Apple tax story to investigate. Apple, like all corporations, manages its tax affairs according to the tax code. “It’s not like it turns out that Apple minimized its tax bill by blackmailing IRS agents by secretly reading their iPhone emails.” That, no doubt, will be in the movie.

Harsh winter weather is expected to have hit the operations of Canadian National Railway Co. in the first quarter while leaving its smaller rival, Canadian Pacific Railway Ltd., largely unscathed.

Thomas Wadewitz, JPMorgan analyst, said he expected one less operating day this year and the winter weather to drag on the volumes of most major railways by about a percentage point in the first quarter.

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He said that he was anticipating “significant cost headwinds” during the quarter at CN, which was hit by multiple heavy storms, causing congestion in February and March on its Edmonton to Winnipeg mainline.

He lowered his earnings expectations for CN during the quarter to $1.27 a share, from $1.30 a share previously, as a result.

“We believe that [CN] stock is likely to perform relatively worse than the other North American railroads over the next several quarters and we continue to rate [CN] underweight,” he said.

He did, however, raise his price target on the stock to $96 a share, from $89 previously, after increasing his multiple for its shares on the belief that the rail group will sustain above average valuation in the near term.

Mr. Wadewitz was more optimistic on an upside surprise from CP in the first quarter in part on a favorable mix of crude oil and potash volumes.

“More importantly, we believe that CP is likely to deliver upside on the cost side driven by significant reduction in train starts and headcount which overwhelm the headwind from higher stock based compensation,” he said.

“We believe there is likely upside to our forecast of $1.25/share which is above consensus of $1.21,” he added.

He has a $148 a share price target on CP and an overweight rating.

Walter Spracklin, RBC Capital Markets analyst, had already lowered his expectations for CN during the quarter to $1.20 earnings per share last month.

“We consider CNR’s growth pipeline to be fully priced into the stock at current levels,” he said. “We also believe that share price appreciation in [the first quarter] might have been limited by a lack of potential near-term catalysts and weak operating trends. “

He has a $96 per share price target on the stock and sector perform rating.

Mr. Spracklin did, however, agree CP carries the potential for an upside surprise in the first quarter and raised his earnings per share estimate to $1.24, from $1.05 previously, for the quarter on the expectation that volume growth has been strong and supported by a longer length of haul for its shipments.

“Further, we expect this, together with operating improvement to offset share-based compensation and fuel cost inflation in the quarter,” he said.

He increased his price target to $104 a share, from $100 previously, and reiterated his sector perform rating.

It wasn’t too long ago that Canada’s largest banks pined for membership in the exclusive and powerful club of the world’s largest financial giants. Now that the 2008 financial meltdown is transforming megabanks from once-mighty emblems of national pride to international pariahs, they could well end up becoming fixtures among their global peers.

In recent weeks, there’s been a major push to restructure megabanks with new regulations beyond internationally accepted capital standards. The reforms being proposed are intended to dramatically overhaul banks by preventing them from taking excessive risks, protecting consumer deposits from risky trading activity, and reducing the threat to the financial system and the economy should a big bank get into trouble. In other words, financial institutions targeted as too-big-to-fail are being reconfigured into entities that are less hazardous for consumers and taxpayers, even if it results in a banking sector that’s less profitable for investors.

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Under consideration to deal with these too-big-to-fail institutions are strategies that range from legislation that would cap the size of big banks, ring-fence operations, force them to raise more capital, and even arming regulators with powers to shut down financial institutions that don’t play along.

In some quarters, such as the U.K. and the U.S., the question isn’t whether large banks will be forced to restructure, rather, how should it happen?

In Canada, the world looks different. Steps to remedy or prevent future meltdowns have been mostly in lock-step with commitments to Basel III, international rules designed to increase capital standards and set new requirements on bank liquidity and leverage. There’s no talk of downsizing or ring-fencing. The configuration of our financial institutions, besides their relative lack of size and scope outside Canada, are arguably two major reasons why the Big Five banks were left standing and relatively unscathed in the aftermath of the financial crisis.

Furthermore, some of the more far-reaching prescriptive measures being proposed in other countries seem inappropriate for the Canadian system already tightly regulated by the Office of the Superintendent of Financial Institutions (OSFI), which historically has taken a conservative and hands-on approach to regulation.

As OSFI prepares to identify domestic banks that are “systemically important” on a national basis, the pinstripes on Bay Street are privately griping about regulatory overload and having less money to play with. The designation will result in higher Tier 1 capital requirements, and inevitably crimp bank profitability and shareholder returns.

Still, OSFI’s higher minimum capital requirements look like minor tinkering compared with the drastic measures being advocated in other countries.

On Feb. 4, British regulators were given new powers allowing them to forcibly split up banks that fail to separate risky trading in investment banking units from deposit-taking retail banking. According to George Osborne, Chancellor of the Exchequer, if a bank defies the rules of separation, British watchdogs will soon have the unprecedented power to break it up.

Last month, the Federal Reserve Bank of Dallas called for too-big-to-fail banks to be downsized into smaller, less-complex institutions, echoing calls from members of Congress on both sides of the floor. In a speech on Jan. 16, Richard W. Fisher, the Dallas Fed’s president and chief executive, criticized the Dodd–Frank Wall Street Reform and Consumer Protection Act as not doing enough to “constrain the behemoth banks” and the heightened risk of economic damage they pose.

Consider that three of the four largest U.S. banks — JPMorgan, Chase & Co., Bank of America Corp. and Wells Fargo & Co. — are bigger today than they were in 2007.

According to Fisher, there were about 5,600 commercial banking operations in the U.S. in the third quarter of 2012. Twelve banks held assets valued at between US$250-billion and US$2.3-trillion, accounting for only 0.2% of U.S. banks but they held a whopping 69% of the industry’s total assets. Fisher predicts the next financial crisis in the U.S. could cost more than two years of economic output, adding “that horrendous cost must be weighed against the supposed benefits of maintaining the TBTF [too-big-to-fail] status quo. To us the remedy is obvious: end TBTF now.”

Even so, while there is growing concern in the U.S. that Dodd-Frank has failed to curb the growth of large banks, there is no consensus on what, or whether, to do anything about it. Still, while major U.S. banks face the possibility of being downsized, their Canadian counterparts, currently enjoying rock star status among the world’s financial institutions, should be able to improve their respective competitive positions.

And to think, all of it aided by a growing desire to improve the safety of the global financial sector. Safety and soundness, now how Canadian is that, eh?

Jamie Dimon is hardly the villain seen in Richard Gere’s new movie Arbitrage

When I saw Richard Gere’s hairstyle in his new movie, Arbitrage, I couldn’t help thinking of the steely-grey coiffure of JPMorgan Chase CEO Jamie Dimon. And sure enough, it seems that Mr. Gere has had Mr. Dimon on his mind. The Hollywood star revealed in an interview recently that he thinks that Mr. Dimon is more like the character he plays in the movie than, say, Bernie Madoff, because Mr. Madoff was a sociopath.

Now there’s a compliment.

“Jamie Dimon is more like this guy than Madoff.… Very equipped. Charming. An alpha personality. It’s inconceivable to him that he wouldn’t win every bet. But the hubris of that, that you’re never going to lose, is insane. And how do you fix the mistake that was unthinkable? This movie’s not just about finance, but personal failing.”

Mmm. JPMorgan certainly lost a few billion on bad market bets this year, but I seem to have missed the bit where Mr. Dimon was guilty of malfeasance and reckless homicide, like Mr. Gere’s character in Arbitrage, Robert Miller.

Miller is a hedge fund manager, art dealer and potential inductee into the Giving Pledge who is playing smoke and mirrors with the people to whom he is selling his company, lying to his business partner (who happens to be his daughter), forcing his employees to cook the books, and cheating on his wife. Then, to top it all, he falls asleep at the wheel of his girlfriend’s car, crashes and kills her. Fast forward a few improbably plot twists and it begins to look as if he might get away with it all, except that he needs his wife (Susan Sarandon) to lie for his alibi, and she — who has known about his philandering all along — demands that he sign over everything. The film ends with Miller accepting a humanitarian award, but without resolution, suggesting that he might just get away with it, and that this sort of thing is destined to go on and on. Just like anti-Wall Street movies.

In real life, it seems that Jamie Dimon’s biggest error may have been to be persuaded by the Federal Reserve to take over floundering Bear Stearns early in 2008. Recently, another branch of government demonstrated its gratitude by filing a lawsuit against JPMorgan for Bear’s activities before Morgan took it over.

Speaking in Washington this week, Mr. Dimon noted that he told a senior regulator at the time, “Please take into consideration when you want to come after us down the road for something that Bear Stearns did, that ­JPMorgan was asked to do this by the federal government.”

He should have got that in writing. Meanwhile, is it entirely inconceivable that Mr. Dimon might have thought that he was acting in the national ­interest?

Nah. He’s from Wall Street, so he and ­Bernie Madoff — who pulled off the biggest Ponzi scheme in history — can be safely assumed to be one under the skin.

Mr. Madoff, who is now serving as much as he can of a 150-year sentence, would appear the ideal Wall Street movie villain, embodying the zero-sum narrative that all Big Finance films have embraced since the original, magnificent 1987 Wall Street. Perhaps the most significant speech given by Michael Douglas’s Gordon Gekko was not the “greed is good” oration but the rambling self-incrimination that he delivers in his office. Not only does Gekko indict the “1%” (thus making writer/director Oliver Stone the leading theoretician of the Occupy movement), he suggests that he makes nothing, he just “owns,” and wrecks companies for the sake of wrecking them: creative destruction without the creative bit. The zero-sum, screw-everybody-else theme was also pursued in Margin Call, in which a Wall Street firm survives by unloading toxic junk on all its competitors. Jeremy Irons gives a wonderfully sinister and — need I say — morally bankrupt performance as the firm’s chairman.

The problem with Bernie Madoff is that his was too straightforwardly corrupt. Far more interesting — as portrayed in Jeff Prosserman’s documentary Chasing Madoff — is the story of Harry Markopolos, the analyst hero who first spotted Madoff’s fraud and spent nine years furiously blowing whistles to no effect. (Mr. Markopolos was in Toronto on Thursday promoting his new book No One Would Listen.)

Although Mr. Markopolos’s story has plenty of private-sector villains in the form of the institutions who were “feeding” clients into Madoff’s web for fat fees, and were thus all too eager to believe his impossible returns, the biggest villain was the SEC, whose story is one of stunning systemic regulatory incompetence, and perhaps worse.

Such incompetence is also a more subtle — but even more threatening -— subtheme of the 2011 HBO docudrama, Too Big to Fail, which is based on Andrew Ross Sorkin’s book on the 2008 meltdown.

While U.S. Treasury secretary Hank Paulson is portrayed by William Hurt as a sympathetic figure losing sleep over the Biggest Imaginable Problem, he also clearly blunders by letting Lehman go under (which came as such a shock because of the Bear Stearns precedent) and is not shy of twisting arms and issuing threats. Then head of the Federal Reserve Bank of New York, and Paulson’s successor at Treasury, Timothy Geithner, comes up with corporate consolidations off the top of his head. Paul Giamatti’s Ben Bernanke is a deer in the headlights.

The question raised by Too Big to Fail is not the one that hangs over the film’s conclusion — will the banks lend all this money that has been sloshed out to them? — it is: Are these desperate government officials actually setting up the next depression rather than averting it?

Generally, the investment bankers don’t come off too badly, with the exception of Lehman’s Dick Fuld. Indeed, the guy who comes off looking the most calm and responsible is Jamie ­Dimon.

Dimon, CEO of JPMorgan Chase & Co, has had to postpone new repurchases of the bank’s stock, and on Wednesday regulators forced his company to reduce its calculation of its capital cushion against losses, all because of derivatives losses related to a trader known as the “London Whale.”

In a filing on Thursday with the Securities and Exchange Commission, JPMorgan said it now hopes to restart its stock buyback program in the first quarter of 2013, roughly three months later than the goal Dimon set in a meeting with institutional investors and stock analysts in July.

The company also disclosed in the filing that regulators had forced the bank to recalculate capital levels to reflect their views on risk models the company used for some of its positions, including some at its Chief Investment Office, which racked up the derivatives losses.

JPMorgan changed a key risk model in the CIO and lost control over the accuracy of its financial reporting in the first quarter as the office built up a massive credit derivatives portfolio that had trading losses of nearly $6 billion.

JPMorgan said it was informed on Wednesday by the U.S. Office of Comptroller of the Currency and the Federal Reserve Bank of New York that changes were needed in its capital calculations.

Former CIO trader Bruno Iksil became known in the derivatives market as the “London Whale” for the size of the positions he took. The name has stuck to the affair even as the bank has said others were involved.

The losses, a major embarrassment for Dimon, also led JPMorgan on Thursday to formally restate its first-quarter results, as it previously said it would.

Though the losses were never seen as big enough to threaten JPMorgan’s position as one of the strongest U.S. banks, the company suspended stock repurchases in May to rebuild capital it had lost.

Dimon said in April that he wanted to buy back shares when they were cheap to increase the value of the remaining shares outstanding. He suggested then that the shares were a bargain for the company at less than about $45.

The shares traded Thursday morning at $36.99, down 0.5 percent for the day and 9 percent lower than before the derivatives problem was disclosed by the company on May 10.

For JPMorgan to resume stock repurchases, it must win approval from the Federal Reserve after another annual stress test of its balance sheet, and the company’s board of directors must complete their own investigation of the CIO, according to the Thursday filing.

JPMorgan Chase & Co. was downgraded to hold from buy at Deutsche Bank on concerns that earnings expectations may be too high, capital deployment may disappoint and regulatory/legal matters remain uncertain.

Analyst Matt O’Conner noted that the recent rally in JPMorgan shares means the stock is down only about 9% since billions in second quarter trading losses were disclosed on May 10.

During this period, however, Deutsche Bank has trimmed its 2013 estimates by 10% as a result of the losses. Share buybacks were also suspended, management credibility took a hit, first quarter results for 2012 were restated and other issues have been raised, Mr. O’Conner told clients.

“For most of the past 5 years, several US competitors have been focused on de-risking, boosting liquidity and rebuilding capital. But risks at most peers no longer seem to be outsized vs. those at JPM, liquidity and capital differences have narrowed and certain peers seem ready to be more aggressive in maintaining/gaining market share,” the analyst said.

“We believe this implies additional market share gains for JPM will be less likely and may suggest some share loss in certain areas (such as capital markets, following huge gains in recent years).”

Mr. O’Connor also cut his price target on JPMorgan shares to US$40 from US$43.

NEW YORK — A criminal investigation into employees of JPMorgan Chase & Co is focusing on several people who worked for the investment bank in London, a source said.

JPMorgan said its traders may have deliberately hidden losses that have since climbed to US$5.8-billion for the year, in a development that may result in criminal charges against traders at the bank.

The bank’s Chief Investment Office made big bets now known as “the London Whale trades” on corporate debt using derivatives. JPMorgan said in the worst-case scenario those trades will lose another US$1.7-billion, and it has fixed the problems in the CIO’s office.

Even with the bank’s trading losses, it earned nearly US$5-billion overall in the second quarter, thanks to strong performance in areas like mortgage lending.

But JPMorgan’s disclosure that CIO traders may have lied about their positions could bring even more intense regulatory scrutiny to the bank, analysts said. It is already under investigation by agencies ranging from the FBI to the UK’s Financial Services Authority.

An internal review found that some of the CIO traders appear to have deliberately ignored the massive size of their trades — and the difficulty in liquidating them — when valuing their positions. The result was not reporting the full declines in the value of positions.

“I see little doubt that someone is going to get charged with fraud,” said Bill Singer, a lawyer at Herskovits in New York who provides legal counsel to securities industries firms, and publishes the BrokerandBroker website. Criminal charges are possible, he added.

The trading losses and possible deception from traders are a black eye for JPMorgan Chief Executive Officer Jamie Dimon, who was respected for keeping his bank consistently profitable during the financial crisis.

]]>http://business.financialpost.com/news/jpmorgan-traders-in-london-probed-over-allegedly-hiding-derivatives-losses-source/feed0stdPeople are seen in the lobby of JP Morgan Chase's international headquarters on Park Avenue in New York.Will JPMorgan’s trading loss be big enough to justify stock’s decline?http://business.financialpost.com/investing/trading-desk/will-jpmorgans-trading-loss-be-big-enough-to-justify-stocks-decline
http://business.financialpost.com/investing/trading-desk/will-jpmorgans-trading-loss-be-big-enough-to-justify-stocks-decline#commentsThu, 12 Jul 2012 12:48:21 +0000http://business.financialpost.com/?p=193781

Trading losses will be the focus when JPMorgan Chase & Co. reports second quarter result on Friday, with estimates ranging from US$2-billion to as much as US$9-billion.

In its public announcement about trading problems in early May, JPMorgan indicated the trading loss would likely be at least US$2-billion. However, the company has not responded publicly to a July 11 Wall Street Journal story suggesting the trading loss could be US$5-billion, nor an earlier New York Times report pegging the loss at US$9-billion.

“We believe if the gross trading losses are $5 billion or less and the company can prove it has ‘ring fenced’ the problem, the stock will rally (assuming its core businesses report solid-to-good results),” said Gerard Cassidy, analyst at RBC Capital Markets. “Trading losses above $5 billion and a discovery that the chief investment office contributed a high percentage to historical earnings would likely lead to the stock ‘selling-off’, in our opinion.”

RBC’s core earnings per share estimate of US$1.07 for the second quarter of 2012 assumes trading losses of US$1.8-billion and US$1-billion in security gains.

Mr. Cassidy left his outperform rating and US$50 price targeton JPMorgan shares unchanged, implying upside of nearly 45% from Wednesday close of US$34.59.

He noted that the company continues to have plenty of capital and generates enough income in other businesses to cope with this loss.

Since first reporting the loss on May 10th, JPMorgan’s market cap has fallen nearly US$24-billion. However, Mr. Cassidy does not believe the trading losses will reach the level necessary to justify such a decline.

Given the recent controversy surrounding JPMorgan Chase & Co., it seems fitting that it will kick off second quarter earnings season for U.S. banks on Friday the 13th.

While expectations for JPMorgan are very low, with earnings per share forecast to decline 41% on a quarterly basis, the results will also confirm whether the bank’s trading losses have risen from an initial estimate of US$2-billion.

Wells Fargo & Co. will also report on July 13 as earnings from all banks will provide a glimpse of how helpful the Federal Reserve’s continued efforts to keep mortgage rates at multi-decade lows has been for refinancing volumes and margins.

Stonecap Securities analyst Brad Smith expects all eyes to be fixed on JPMorgan’s trading results in order to determine if the bank’s troubles are isolated or if they are shared by others.

“For Canadian banks, the results will provide some guidance with respect to credit trends which are anticipated to have remained benign despite recent economic setbacks in terms of employment and incomes,” Mr. Smith said in a note to clients.

Given that expectations vary widely across the banking sector, the analyst anticipates that valuation volatility will remain elevated over the medium term.

Banksters are being exposed one after another for indulging in widespread interest rate manipulation, power market collusion and municipal bond bid rigging.

All these allegations are disheartening so it was with some relief that, on the other hand this week, scientists announced they had found the ‘‘God particle’’, whatever that is. Unfortunately, no one can define this or describe where it is, but it’s certainly missing on Wall Street, the City of London and the world of finance.

The most recent scandal concerns the Libor, an acronym for the London inter-bank offered rate, which affects the setting of worldwide interest rates. Police and regulators maintain major banks around the world gamed this process to profit. Heads have fallen at Britain’s Barclays Bank PLC over this, the institution has been levied with a US$450-million fine for its shenanigans and its stock plunged 16%.

Barclays’ CEO, a rich Yank that Fleet Street has pilloried for addressing parliamentary inquiry members by their first names, has been driven out of office. So have others and there will be more to come. It appears as though 16 banks may be involved.

The Economist underscored the significance of this revelation: “It is among the most important prices in finance. So allegations that Libor has been manipulated are a serious worry. Libor is meant to be a measure of banks’ own borrowing costs, and is used as the foundation for a host of other interest rates. Everyone is affected by Libor: It influences the payments made on mortgages and personal loans, and those received on investments and pensions.”

People make money on both sides of markets: One man’s trash is another man’s treasure. An industry of corporate ambulance chasers has been suing everything in sight. Professor William Black of the University of Missouri-Kansas City (author of book entitled The Best Way to Rob a Bank is to Own One) said the scale of U.S. litigation could be the “biggest thing in the history of anti-trust by orders of magnitude” and that punitive damages “could bring down any British bank because Americans are big enough players

The U.S. Department of Justice alleges that collusion between traders across a range of banks, including Barclays, took place from at least August 2005 through to at least May 2008.

Libor is just one of many anti-trust cases leveled against rampant banksterism. Another involves an investigation by U.S. energy regulators into power market bidding manipulation by JP Morgan Chase & Co., Barclays Bank PLC and Deutsche Bank AG, plus intermediaries.

These banks were playing around with power market trading – buying and selling electricity – for themselves or clients. Washington’s Federal Energy Regulatory Commission alleges trading activities hiked electricity prices and resulted in higher power bills to homeowners and consumers across the U.S.

A third case grinds away in courts, without much fanfare, but involves some of the same banks. This concerns allegations about manipulation of municipal bond rates that cost local and state governments millions over a number of years.

So far, the Bank of America Corp., JPMorgan Chase & Co., UBS AG, Wells Fargo & Co. and GE’s former trading unit called GE Funding have paid $743 million to settle a criminal probe and civil claims for conspiring to rig bids on U.S. municipal-bond deals. Some money has been returned to victims.

The case involving GE went to court and revealed how the scams were done. The Securities and Exchange Commission said GE Funding made millions by rigging 328 transactions in 44 states. GE operatives would get information about competing bids then adjust theirs accordingly. Sometimes they would take turns, with other intermediaries, putting in bids that were guaranteed to lose. Three individuals have been convicted of anti-trust violations.

Clearly, banks are no longer banks but casinos. They bet rather than lend to make obscene profits and bonuses that has tempted some to rig the results. GE aside, commercial banks should never be able to wager deposits from ordinary people that ordinary people, as taxpayers, have insured. It’s time to bring back Glass Steagall and finally separate speculation from traditional banking.

Banks should be divided into utilities, for the greater economic good, and casinos, said Bank of England Governor Sir Mervyn King years ago. Hopefully, the British inquiry underway into Libor will lead the world and Sir Mervyn hopes the UK can force “a real change in culture” that others will emulate.

]]>http://business.financialpost.com/diane-francis/new-bank-misdeeds-show-financial-industry-in-need-of-overhaul/feed0stdBarclays’ CEO Bod Diamond, a rich Yank that Fleet Street has pilloried for addressing parliamentary inquiry members by their first names, has been driven out of office. So have others and there will be more to come. It appears as though 16 banks may be involved.Ex-JPMorgan trader wins big in betting against bankhttp://business.financialpost.com/news/ex-jpmorgan-trader-wins-big-in-betting-against-bank
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Andrew Feldstein, who bet against JPMorgan Chase & Co. before helping the bank unwind more than US$20-billion of trades, has emerged as one of the biggest winners among hedge-fund managers profiting from a flawed strategy.

The $4.3-billion flagship fund of Feldstein’s BlueMountain Capital Management LLC returned 9.5% this year through June 22, according to a person familiar with the data. That’s up from the 5.4% return before JPMorgan announced a US$2-billion loss by one of its traders known as the London Whale. BlueMountain, which was on the other side of those wagers, stands to make as much as US$300-million, said market participants familiar with the trades.

Andrew Feldstein is one of the most creative and sophisticated investors in fixed income

Feldstein, a former JPMorgan executive who helped the company create the credit-derivatives market, profited by exploiting price distortions caused by the outsized bets and then aiding the bank in unwinding the trades as it sought to cap the loss, according to four people with knowledge of the strategy who asked not to be identified because the matter is private. BlueMountain enabled JPMorgan to unload more than US$20-billion of bets on a credit-swaps index, two of the people said.

“Andrew Feldstein is one of the most creative and sophisticated investors in fixed income,” said Sarah Quinlan, founder of hedge-fund advisory firm QAM in New York and a former BlueMountain investor. “It is not surprising that JPMorgan would reach out to him to assist in the unraveling of this complicated and very public situation.”

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By assisting JPMorgan in unwinding its trades, Feldstein, 47, enabled the bank to take losses in the second quarter and move ahead with less uncertainty, said Adrian Miller, director of global markets strategy at GMP Securities LLC in New York. BlueMountain also helped JPMorgan Chief Executive Officer Jamie Dimon put behind him a trading debacle that brought scrutiny from Congress and regulators and tarnished his reputation as one of the industry’s best risk managers.

Dimon “will be judged by how this problem is rectified,” Miller said.

Feldstein’s profit from betting against JPMorgan probably exceeds that of Boaz Weinstein, the Saba Capital Management LP founder who gained media attention for recommending the trade at a February hedge-fund conference in New York. His main fund, with US$5-billion in assets, is up 2.3% this year as of June 22, according to a person familiar with Saba’s returns.

Doug Hesney, a spokesman for BlueMountain, declined to comment, as did Kristin Lemkau of JPMorgan.

Obama Basketball

JPMorgan hired Feldstein, a graduate of Georgetown University and Harvard Law School, in 1992, as it was developing a new market that allowed banks to pay investors to take on the risk that companies default on their debt. Those financial instruments, known as credit-default swaps, evolved into a market with more than $62 trillion of outstanding contracts at its peak in 2007.

A former Harvard Law classmate of Barack Obama’s who played pickup basketball with the future U.S. president, Feldstein has kept a low profile outside financial markets, rarely giving interviews. He lives in Scarsdale, New York, in a home he and his wife purchased for US$4.6-million in 2006, according to real estate records, and contributed to both Obama and Republican candidate John McCain in 2007. In her 2009 book “Fool’s Gold,” about JPMorgan’s creation of the credit-swaps market, Gillian Tett described him as introverted and “exceedingly bright.”

‘No Ego’

“He’s a very modest individual,” said William S. Demchak, president of Pittsburgh-based regional lender PNC Financial Services Group Inc., who hired Feldstein at JPMorgan. “The reason he doesn’t talk publicly is he has no ego. He’s not a master of the universe and wanting to make big bets and be a hero. He comes to work every day and tries to, with his team, earn a sensible return on the money they’re investing.”

Feldstein and Demchak later teamed up to raise money for the Darfur Project, which from 2007 to 2009 sponsored airlifts of food and medicine to those affected by conflict in Sudan’s Darfur region.

Since starting New York-based BlueMountain in 2003 with Harvard Law friend Stephen Siderow in a spinoff from BlueCrest Capital Management LLP, Feldstein has earned a reputation as a master arbitrager. His hedge fund has generated almost 10% annual average returns largely by spotting abnormalities in the price relationships in credit swaps. Rather than bet on whether the price of a company’s debt will rise or fall, the fund often takes both sides of the trade and profits when the price relationships revert to normal.

Goldman Counterparty

“Our objective is to avoid placing any bets on these macro outcomes,” Feldstein said in a Bloomberg Television interview that aired Dec 22. “We don’t think they’re very predictable.”

With complex trades that can sometimes have more than 100 separate pieces, that strategy also has helped make BlueMountain one of Wall Street’s biggest clients.

By June 2008, BlueMountain was Goldman Sachs Group Inc.’s fourth-largest counterparty in the credit-derivatives market, with US$590-billion of outstanding contracts, bigger than that of banking giants Barclays Plc and Credit Suisse Group AG, according to a 2010 report by the Financial Crisis Inquiry Commission, a U.S. panel that investigated the credit seizure.

Goldman Sachs at the time was acting as a prime broker for BlueMountain, loaning money and securities and clearing credit- swaps transactions, according to two people familiar with the firm, who asked not to be identified because they aren’t authorized to discuss the business.

Saving BlueMountain

The hedge fund’s trading book reached the size it did in large part because, rather than tear up the bulk of its swaps when it was ready to close out a position, BlueMountain put on offsetting trades to cancel them out, the people said.

After Lehman Brothers Holdings Inc.’s 2008 bankruptcy, as fears of a cascade of bank and hedge-fund failures gripped markets, BlueMountain faced an exodus of investors, even as its flagship Credit Alternatives Master Fund outperformed an industry average tenfold. Feldstein moved to bar withdrawals and freeze US$3.1-billion of assets.

BlueMountain shifted almost all of its trades out of Goldman Sachs. Most of those went to JPMorgan, now the fund’s biggest prime broker, perceived by the market at the time as a more creditworthy counterparty, according to a person familiar with the fund. Tiffany Galvin, a Goldman Sachs spokeswoman, declined to comment.

Feldstein laid out a plan to restructure the fund, and investors owning 80% of the assets agreed to keep their money in place while markets improved, according to a November 2008 letter to investors, a copy of which was obtained at the time by Bloomberg News.

Gap Arbitrage

The credit-alternatives fund, which lost 6% in 2008, went on to return 24.4% in the first eight months of 2009 as markets recovered from the crisis, according to a letter to investors at the time.

One of the trades BlueMountain has mastered better than almost any other hedge fund, according to market participants, involves arbitraging the gap between credit-swaps indexes and contracts on the companies tied to those benchmarks. When the cost to buy protection on the index drops below the average cost of swaps on the companies, the fund will purchase protection on the benchmark and sell it on its constituents, profiting when the swaps converge.

London Whale

That was the opportunity that funds from BlueMountain to Saba noticed last year as a trader in JPMorgan’s chief investment office in London, Bruno Iksil, began making outsized bets on the Markit CDX North America Investment Grade Index Series 9. The index, known as IG9, is tied to 121 companies that were investment-grade when it was created in September 2007, including now junk-rated bond guarantor MBIA Insurance Corp., a unit of MBIA Inc., and retailer J.C. Penney Co.

Dimon, 56, transformed the chief investment office in recent years to make bigger and riskier speculative trades with the bank’s money, Bloomberg News first reported April 13, based on information provided by five former employees. Iksil managed a portfolio of credit swaps that, Dimon told the Senate Banking Committee June 13, was intended to profit in a financial crisis and make “a little money” in a benign market.

Iksil’s group was instructed to cut positions in December in anticipation of new capital rules, Dimon told the Senate panel. Instead Iksil, who became known as the London Whale for the size of his bets, sought to offset the hedges by selling protection on the IG9 index through December 2017 to dealers such as Bank of America Corp. and Citigroup Inc., which in turn sold that protection to money managers including BlueMountain and Saba, market participants said.

Iksil’s Bets

In the 14 weeks ended April 6, outstanding bets on the index using credit swaps surged an unprecedented 65% to US$148.2-billion, according to the Depository Trust & Clearing Corp., which runs a central registry for the market.

The net amount of credit-derivatives protection the bank sold on investment-grade companies using contracts expiring in more than five years doubled to US$101.3-billion in the three months ended March 31, Federal Reserve data shows.

Iksil’s bets were so large that he drove the price of the index far below the average of the underlying companies. That made the price of the index equivalent to buying US$1 of protection for about 80 cents, market participants said. Hedge funds could arbitrage the gap and build positions against JPMorgan by buying swaps on the index and selling CDS on the constituent companies.

Saba, BlueCrest

The potential gains lured BlueMountain, Saba and other hedge funds including BlueCrest and Hutchin Hill Capital LP to buy more protection as Iksil continued offering to sell to brokers — even as it initially led to losses because the JPMorgan trader’s bets moved the index lower.

BlueCrest founder Michael Platt said in a May 21 interview with Bloomberg News that the US$32-billion hedge fund traded in a “small way” to profit from the distortions.

After JPMorgan announced the US$2-billion loss, the cost of the IG9 index surged in anticipation the bank would unwind its bets. The swaps, which had fallen to as low as 102 basis points in March, jumped to 175 on June 5, or US$175,000 a year to protect US$10-million of debt, according to data provider CMA.

“It could easily get worse,” Dimon said of the loss on a May 10 conference call with investors and analysts, when buying protection on the index cost less than 127 basis points, or US$127,000 annually for every US$10-million insured. A basis point is one-hundredth of a percent.

‘Treacherous Landscape’

Exiting the index bets quickly was difficult because they were large relative to the amount that trades on any given day, DTCC data show. Unlike the current version of the index known as Series 18, on which an average US$27.6-billion trades each day, US$5.5-billion of IG9 exchanged hands each day in the 12 weeks ended June 22.

“When you put on a large trade, it’s hard for people not to notice what you’re doing,” Scott MacDonald, head of research at MC Asset Management Holdings LLC in Stamford, Connecticut, said in a telephone interview last month. “It’s a treacherous landscape to be unwinding the trade in.”

That’s where BlueMountain came in. Because the hedge fund executes so many trades in credit swaps to support its arbitrage strategies, and it falls outside the typical web of market- makers, it was in a better position than JPMorgan to take the bank out of a large chunk of its losing bets without tipping off other investors, said two market participants familiar with credit-swaps trading.

IG9 Protection

“Feldstein is a former JPMorgan exec and likely has a good relationship with senior management,” said Miller of GMP Securities. “Since transacting these trades with as little market knowledge as possible is the key to not creating big price fluctuations, who better to go to than a trusted prior colleague?”

Within the past few weeks, BlueMountain, which oversees US$9.2-billion across all of its funds, has been buying default protection on IG9, a position that would offset the bets JPMorgan already has, and then selling it to the bank.

The transactions, first reported by Bloomberg News on June 20, are among trades that may have helped reduce the bank’s exposure to the index by more than half, according to estimates from market participants familiar with trading activity.

Exiting Wagers

Both Saba and Hutchin Hill have exited their bets against JPMorgan, people familiar with the funds said last week. Hutchin Hill returned 2.65% this year through June 22, according to a person familiar with the fund. That compares with a 1.1% gain for hedge funds worldwide over the same period, according to Chicago-based Hedge Fund Research Inc.’s benchmark HFRX Global Hedge Fund Index.

During the three weeks ended June 22, as the cost of the IG9 index contracts fell to 159 basis points from as high as 175, swaps dealers cut the net amount of protection they had sold on the index by 65%, DTCC data show. JPMorgan is the only one of the six biggest U.S. banks to have sold more protection on investment-grade companies than it had bought, Fed data through the end of March show.

Dimon said on May 10 that the bank’s loss could reach $3 billion or more. Charles Peabody, an analyst at Portales Partners LLC in New York, estimated the amount could be between US$4-billion and US$5-billion. JPMorgan hasn’t disclosed how much of the money-losing trades it’s still holding. The bank has said it will provide an update on the loss and where its position stands when it reports earnings July 13.

]]>http://business.financialpost.com/news/ex-jpmorgan-trader-wins-big-in-betting-against-bank/feed0stdFeldstein, a former JPMorgan executive who helped the company create the credit-derivatives market, profited by exploiting price distortions caused by the outsized bets and then aiding the bank in unwinding the trades as it sought to cap the loss, according to four people with knowledge of the strategy who asked not to be identified because the matter is private.SEC investigating JPMorgan risk model disclosurehttp://business.financialpost.com/news/sec-investigating-jpmorgan-risk-model-disclosure
http://business.financialpost.com/news/sec-investigating-jpmorgan-risk-model-disclosure#commentsTue, 19 Jun 2012 16:27:04 +0000http://business.financialpost.com/?p=186659

WASHINGTON – U.S. securities regulators are investigating whether JPMorgan Chase & Co misled investors in its April earnings statement by failing to disclose a change in how it measured risk, Securities and Exchange Commission Chairman Mary Schapiro said on Tuesday.

“Part of what we are investigating is the extent of that disclosure and whether it was adequate, among other things,” Schapiro told lawmakers during a House Financial Services hearing.

Schapiro’s comments were the first time she said explicitly that the SEC is focusing on what the bank disclosed and what Chief Executive Jamie Dimon said on April 13 after news reports about rising risk at the bank’s Chief Investment Office, which turned out to have lost at least US$2-billion trading credit derivatives.

By omitting any mention of model change from its earnings release in April, the bank disguised a spike in the riskiness of a particular trading portfolio by cutting in half its value-at-risk number.

Related

Tuesday was the second time that U.S. financial regulators, as well as Dimon, have appeared before lawmakers to answer questions about the failed hedging strategy.

Schapiro said on Tuesday that although companies are not required to disclose such a model changes in their earnings releases, other SEC rules still require such statements to be truthful and complete.

The agency is looking at the disclosure in light of the fact that it came at the same time that Dimon called reports about heightened risk at the CIO office a “tempest in a teapot,” Schapiro said.

“If you chose to speak, you absolutely must speak truthfully and completely and not allow yourself to leave any kind of misleading impression from the information that you are putting out,” Schapiro told the lawmakers.

“The duty under Federal securities laws is to speak completely and truthfully,” she said.

Dimon made the “tempest in a teapot” comment in a conference call with analysts the day the bank issued the low-risk reading as the company reported first quarter earnings on April 13.

Dimon told a Senate Banking Committee hearing last week that he was “dead wrong” when he dismissed the reports of trouble and that, at the time, he had not focused on the model change.

JPMorgan Chase & Co. chief executive Jamie Dimon said traders in a London unit responsible for a US$2-billion loss didn’t understand the risks they were taking and weren’t properly monitored.

“This portfolio morphed into something that, rather than protect the firm, created new and potentially larger risks,” Mr. Dimon said in prepared remarks ahead of his appearance tomorrow before the Senate Banking Committee. “We have let a lot of people down, and we are sorry for it.”

‘We have let a lot of people down, and we are sorry for it’

Lawmakers plan to question Mr. Dimon at hearings this week and next about the bank’s blunders on credit derivatives in its chief investment office after he initially called April news reports about the trades “a complete tempest in a teapot.” Shares of the bank, the biggest in the U.S., have dropped 17% since Mr. Dimon disclosed the mounting losses May 10, lopping about US$26.5-billion from the firm’s market value.

“CIO’s traders did not have the requisite understanding of the risks they took” on bets that were supposed to hedge credit risk, Mr. Dimon said. “When the positions began to experience losses in March and early April, they incorrectly concluded that those losses were the result of anomalous and temporary market movements.”

Mr. Dimon, who’s also set to face the U.S. House Financial Services Committee on June 19, finds himself in the middle of a renewed debate about whether the so-called Volcker rule, which would curb trading by deposit-taking banks, should be tightened. While Mr. Dimon didn’t comment on the size of the loss from the trades, he said the second quarter would be “solidly profitable.”

“The lessons learned from the recent failures in risk management at JPMorgan Chase will be an important input into efforts to design the Dodd-Frank Act reforms including a strong Volcker rule,” U.S. Treasury Department deputy secretary Neal Wolin told the Senate panel last week.

Related

The bank instructed the CIO in December to reduce its risk-weighted assets to prepare for new international capital rules. Instead, the office in mid-January “embarked on a complex strategy that entailed adding positions that it believed would offset the existing ones,” Mr. Dimon said. The portfolio instead got larger and the problem got worse, he said.

Mr. Dimon said that the risk committee structures and processes were not as robust in the CIO as they should have been. The division’s London team built up a book of credit derivatives that became so large that employees couldn’t unwind it without roiling markets or incurring large losses, current and former executives have said.

The strategy for reducing the portfolio was “poorly conceived and vetted,” Mr. Dimon said. “The strategy was not carefully analyzed or subjected to rigorous stress testing within CIO and was not reviewed outside” the division.

Risk oversight personnel were “in transition” and the derivatives credit portfolio responsible for the loss should have “gotten more scrutiny from both senior management and the firm-wide risk control function,” he said.

The position of chief risk officer inside the CIO was a revolving door, with at least five executives holding the job in six years, people familiar with the matter said. Irvin Goldman, appointed in February and replaced in May, had been fired in 2007 by brokerage Cantor Fitzgerald LP for money-losing bets that led to a regulatory sanction of the firm, said three people with knowledge of the matter. Goldman wasn’t directly accused of wrongdoing.

Chief investment officer Ina Drew retired after the loss was disclosed and was replaced by Matt Zames, who was co-head of fixed-income trading in the investment bank. Mr. Zames told staff that top London-based trading executive Achilles Macris would hand off duties.

Handout/JPMorgan/ReutersChief investment officer Ina Drew retired after the loss was disclosed and was replaced by Matt Zames, who was co-head of fixed-income trading in the investment bank.

“When we make mistakes, we take them seriously and often are our own toughest critic,” Mr. Dimon said. “While we can never say we won’t make mistakes — in fact, we know we will — we do believe this to be an isolated event.”

JPMorgan’s biggest competitors, including Bank of America Corp., Citigroup Inc. and Wells Fargo & Co., have said their corporate investment offices avoid using the kind of derivatives that led to the trading losses and buy fewer bonds exposed to credit risk. The rivals said their offices don’t trade credit-default swaps on indexes linked to the health of companies.

Government Probes

Government investigators are scrutinizing how long senior executives knew about the CIO’s swelling bets before the losses approached $2 billion. One focal point is why the CIO’s so- called value-at-risk formula used to calculate potential losses was altered in this year’s first quarter, cutting the reported risk by half.

When the bank reported first-quarter earnings, the new model showed an average daily VaR within the CIO of $67 million, about where it stood in the previous period. Dimon said May 10 that the bank then reviewed the effectiveness of the new model, deemed it “inadequate” and decided to return to the previous version. On that basis, VaR doubled to $129 million.

Government investigations of JPMorgan include the Federal Reserve’s study of internal oversight, the Office of the Comptroller of the Currency’s look into trading, and the Securities and Exchange Commission’s examination of why the bank changed internal risk gauges this year. The Department of Justice and the Commodity Futures Trading Commission also are conducting inquiries.

Investors and bankers, including Dimon, have speculated that the loss may hurt efforts to soften restrictions imposed by the 2010 Dodd-Frank Act, including the law’s so-called Volcker rule, which limits lenders from making bets with their own money and was designed to head off a repeat of the financial crisis.

JPMorgan Chase & Co. could have spotted trouble at its chief investment office long before traders there racked up at least US$2-billion in losses. One reason it didn’t: Chief Executive Officer Jamie Dimon.

Dimon treated the CIO differently from other JPMorgan departments, exempting it from the rigorous scrutiny he applied to risk management in the investment bank, according to two people who have worked at the highest executive levels of the firm and have direct knowledge of the matter. When some of his most senior advisors, including the heads of the investment bank, raised concerns about the lack of transparency and quality of internal controls in the CIO, Dimon brushed them off, said one of the people, who asked not to be identified because the discussions were private.

‘These institutions are too big to manage’

Dimon’s actions contrast with his reputation as a risk-averse manager who demands regular and exhaustive reviews of every corner of the bank. While Dimon has said he didn’t know how dangerous bets inside the CIO had become, the loss on those trades calls into question whether anyone can manage a financial empire as vast as JPMorgan, which became the biggest U.S. lender last year and now has more than US$2.3-trillion in assets, larger than the economies of Brazil or the U.K.

“These institutions are too big to manage because even the bank that was considered to be the best-managed turns out to have had a significant glitch,” said Gary Stern, a former president and CEO of the Federal Reserve Bank of Minneapolis and co-author of the 2004 book “Too Big to Fail: The Hazards of Bank Bailouts.”

Testifying Tomorrow

The trading breakdown has undermined Dimon’s authority as a critic of regulatory efforts to curb speculation by deposit-taking banks, and triggered government probes in the U.S. and the U.K. It also cost Chief Investment Officer Ina R. Drew, one of the most powerful women on Wall Street, her job. JPMorgan shareholders have seen about US$30.1-billion of market value wiped out since Dimon disclosed the loss.

Dimon may have to account for his decisions as soon as tomorrow, when he’s scheduled to testify about JPMorgan’s trading loss before a Senate committee in Washington. The senators, led by South Dakota Democrat Tim Johnson, may ask Dimon why he didn’t ensure that the chief investment office’s risk managers kept pace with the nature of the unit’s business.

Dimon, 56, declined to comment for this article.

The CIO’s mission includes investing deposits the bank hasn’t loaned. Over the past four years, assets controlled by the unit ballooned fivefold to US$374.6-billion in the first quarter, making it one of the largest money managers on Wall Street. Yet the unit was ill-equipped to handle the size and complexity of its credit-derivative portfolio, according to two former CIO executives and one current executive.

Related

As Dimon encouraged the CIO to take more risk in search of profits, the unit raised limits on positions and sometimes ignored them, the former executives said.

At the same time, the position of chief risk officer inside the CIO was a revolving door, with at least five executives holding the job in six years, according to people familiar with the matter. Irvin Goldman, appointed in February and replaced in May, had been fired in 2007 by brokerage Cantor Fitzgerald LP for money-losing bets that led to a regulatory sanction of the firm, said three people with knowledge of the matter. Goldman, 51, wasn’t directly accused of wrongdoing.

The division’s London team built up a book of credit derivatives beginning in 2008 that became so large by late 2010 that employees couldn’t unwind it without roiling the markets or incurring large losses, according to current and former executives.

London Whale

Risk management at the CIO was a world of its own: This year its traders valued some of their positions at prices that differed from the investment bank, people familiar with the situation have said. One trader built up positions in credit derivatives so large and market-moving he became known as the London Whale. It was those bets on credit-default swaps known as the Markit CDX North America Investment Grade Series 9 that backfired and forced JPMorgan to disclose the trading loss.

While Dimon allowed risks inside the CIO to mount, members of his board lacked the experience to police it. None of the three people on the board’s risk-policy committee has worked as a banker or had any experience on Wall Street in the past 25 years, and one is a museum director.

Dimon’s push to take greater risks in the chief investment office, first reported by Bloomberg News on April 13, began in 2005, not long after New York-based JPMorgan completed its acquisition of Bank One Corp. and he became CEO.

‘New Vision’

He created the CIO, elevated Drew from treasurer to chief investment officer, had her report directly to him and encouraged her department, which had invested mostly in government-backed securities, to seek profit by speculating on higher-yielding assets such as credit derivatives, according to more than half a dozen former executives. Sometimes Dimon suggested positions, such as directional bets on economic trends or asset classes, one current executive said.

“We want to ramp up the ability to generate profit for the firm,” David Olson, a former head of credit trading for the CIO in North America, recalled being told by two executives when he was hired in 2006. “This is Jamie’s new vision for the company.”

Bank of America Corp., Citigroup Inc. and Wells Fargo & Co., the next three largest U.S. banks, say their corporate investment offices follow more conservative strategies and don’t trade credit-default swaps or indexes linked to the health of companies, as JPMorgan is said to have done.

Surging Profits

In 2006, Drew hired Achilles Macris, 50, a former co-head of capital markets at Dresdner Kleinwort Wasserstein, to oversee trading in London and carry out Dimon’s mandate to generate greater profits, three former employees said. When JPMorgan acquired Bear Stearns Cos. and Washington Mutual Inc. at fire- sale prices in 2008 and with government support, the CIO’s portfolio more than doubled to US$166.7-billion from US$76.2-billion the previous year.

Profits surged as assets swelled. The group started making more exotic trades, betting against an index of subprime mortgage bonds in 2007 that resulted in a roughly US$1-billion profit that year, according to one former CIO executive and another person briefed on the trade. The following year, the corporate division, which includes CIO and treasury results, earned US$1.5-billion, compared with a net loss of US$150-million in 2007. Net income for the division was US$3.7-billion in 2009.

Earnings Impact

As large as those numbers were, they understated the CIO’s real profitability. Because Drew, 55, and her traders invested on behalf of JPMorgan’s deposit-taking businesses, some of the income they generated flowed to other departments, such as the retail bank. Macris’s team in London, running a portfolio of as much as US$200-billion in trades, had a profit of US$5-billion in 2010 alone, more than a quarter of JPMorgan’s net income that year, one former executive said.

The CIO may have contributed as much as 80 US cents a share to the company’s earnings, according to estimates by Charles Peabody, an analyst at Portales Partners LLC in New York.

“The issue that is still being underestimated is how much of their core earnings power is going to be reduced by restructuring and reining in that CIO office,” he said in a June 4 interview on “Bloomberg Surveillance.”

In addition to making speculative bets, the CIO took on a bigger role after the financial crisis, hedging JPMorgan’s potential losses on loans and corporate bonds by taking positions in credit derivatives.

CIO Oversight

The question of CIO oversight arose in the months after the crisis, when top JPMorgan executives heard what Macris and his fellow traders in the London office were doing and raised concerns to Dimon that the unit’s risk management was inadequate, according to the two executives familiar with the conversations.

William Winters and Steven Black, co-heads of JPMorgan’s investment bank at the time, were among those who sought more information about the CIO’s changing risk profile, according to people who participated in or witnessed the conversations.

James “Jes” Staley, 55, who ran asset management at the time and now heads the investment bank, and John Hogan, then the investment bank’s chief risk officer, also questioned why risk controls inside the CIO weren’t as extensive or robust as in other departments.

Visibility Lacking

“That’s absurd,” said Kristin Lemkau, a spokeswoman for the bank. Winters, Black and Staley never complained about a specific risk in the CIO’s office, she said. If they had, Dimon’s protocol would have been to gather the relevant data, let them talk to Drew and return to him if they weren’t satisfied with her response, a bank executive said. The operating committee, on which they all sat, also could have reviewed the matter if they still had concerns, the person said.

Timothy A. Clary/Getty Images filesThe JPMorgan building in New York.

It’s also “totally untrue” that Hogan questioned why the CIO didn’t have as effective or robust risk controls as other divisions, Lemkau said.

One sore spot for executives inside the investment bank was the lack of visibility into CIO positions, according to two people with direct knowledge of the matter. While the weekly risk-committee meetings held by the investment bank were open to members of senior management and were attended regularly by Macris and occasionally by Drew, parallel sessions run by the CIO were closed to anyone outside the unit, these people said.

Chinese Wall

Among the explanations offered for Drew’s autonomy: There was a so-called Chinese wall between the CIO and investment bank because Drew’s unit was also a client, according to one current and two former executives. The CIO used the investment bank to place and process trades. Drew didn’t trust that division to refrain from using the data to its advantage by offering non- competitive prices or by trading against her, according to a former executive who participated in those talks.

It also was widely known within the bank that Winters, 50, and Black, 60, didn’t get along with Drew, according to a current and a former executive.

A person close to the bank offered a different description of the circumstances: While Dimon didn’t adopt a double standard for Drew, he and other senior executives became complacent toward the CIO over time as a result of her track record as a consistent money maker, this person said.

Winters and Black proposed redefining the role of Ashley Bacon, then head of market risk for the investment bank, to extend his oversight to the CIO, a former bank official said. The executives also asked that CIO risks be disclosed in greater detail at review meetings and that other members of the bank’s operating committee be involved in assessing them.

Dimon’s Response

Dimon’s response, one of the people said, was that the situation was under control. It was an answer that one former executive said he got from Dimon again and again, as risks in the CIO grew to potentially perilous levels.

“You really need people who have a very broad view of things both quantitatively and with market knowledge and have the clout within the firm to actually be heard,” said Emanuel Derman, a former head of quantitative risk strategies at Goldman Sachs Group Inc., a professor at Columbia University and author of “My Life as a Quant” and “Models Behaving Badly.” “To say that it’s OK with the desk is not the right thing to do.”

In 2009, Dimon fired Winters and relieved Black of operating responsibility. Staley took over as head of the investment bank, and Mary Erdoes, 44, succeeded him at asset management. Winters, Staley and Hogan declined to comment on the discussions. Black didn’t return phone calls seeking comment.

‘Structural Deficiencies’

Dimon and what he called his “fortress balance sheet” meanwhile were being lauded by politicians and the media. He steered JPMorgan through the 2008 financial crisis without a single quarterly loss. New York magazine dubbed him “Good King Jamie,” while a biography by Duff McDonald was titled “Last Man Standing: The Ascent of Jamie Dimon and JPMorgan Chase.”

‘In the wake of the financial crisis, he came to represent this notion that, if well-managed, a bank didn’t need to be regulated all that heavily’

“In the wake of the financial crisis, he came to represent this notion that, if well-managed, a bank didn’t need to be regulated all that heavily,” said Rakesh Khurana, a management professor at Harvard Business School in Cambridge, Massachusetts, and author of “Searching for a Corporate Savior: The Irrational Quest for Charismatic CEOs.” “That may have contributed to some structural deficiencies in governance and risk management. It probably created the benefit of the doubt to his direction in the board room and probably a lot of deference to his authority in day-to-day operations.”

Drew spent three decades at the firm and its predecessors, helping steer it through the Russian debt crisis and the collapse of hedge fund Long-Term Capital Management in 1998.

Longer Leash

At first, she maintained tight control over the CIO’s trades, former colleagues and employees said. She ran the group’s daily 7 a.m. meetings in a seventh-floor conference room at JPMorgan’s headquarters at 270 Park Ave. in Manhattan, according to former traders. She placed strict limits on how much an investment could lose or gain, and traders were required to exit positions if losses exceeded a certain amount, according to one former manager in London and several former traders.

Macris gave traders a longer leash and imposed fewer controls, according to three former executives. So-called stop- loss limits, which were supposed to trigger an internal review or require a trader to immediately exit a position if losses grew too large, weren’t always enforced, the executives said. Macris didn’t respond to e-mails or phone calls seeking comment.

The shift in risk appetite led to the departures in 2008 of some traders who specialized in more-liquid markets where risk was easier to measure, such as interest-rate products and foreign exchange, three other former CIO executives said. Under Macris, the CIO’s London office bought European mortgage-backed securities, structured credit and other assets that brought higher yields and more risks than the safest short-term Treasury bonds.

Boeing 747

Peter Weiland, who graduated from Princeton University with a degree in chemistry and had been overseeing risk for JPMorgan’s proprietary-trading group, was transferred in 2008 into the same role at the CIO. He immediately saw faults in the division’s risk-management system, said two former executives who worked with him.

While Drew hired traders and quantitative analysts needed for trading, she failed to add the staff, computer models or technology necessary to evaluate the new risks, a former and a current executive said. The risk-management systems and framework designed to spot potential pitfalls, especially in credit derivatives, didn’t keep pace with the portfolio’s expansion, the people said.

Changing VaR

Weiland became concerned that Bruno Iksil, the trader in Macris’s office now known as the London Whale, had amassed a complex and illiquid position, according to two former executives. Weiland, who declined to comment, warned Macris and Drew about the trades on numerous occasions beginning in 2010, the people said. It was a topic of frequent discussions in the CIO’s global weekly meetings, they said.

Weiland compared efforts to reduce Iksil’s outsized position to the difficulty of trying to safely land a Boeing 747 without flying lessons, one executive said. The position was so large and illiquid, Weiland said he couldn’t get the plane below 35,000 feet, the executive said.

By 2010 Iksil’s value-at-risk, or VaR — a formula used by banks to assess how much traders might lose in a day — already was US$30-million to US$40-million, a person with knowledge of the matter said. At times the figure surpassed US$60-million, the person said, about as high as the level for the firm’s entire investment bank, which employs 26,000 people.

Too Illiquid

Drew, who resigned last month after the CIO losses were announced, was on sick leave for about six months in 2010, during which time Macris and Althea Duersten, head of the CIO for North America, ran the division. The daily meetings were moved to a larger conference room near their new offices on the 10th floor to accommodate about 40 people in attendance. Drew relocated to the executive suites, more than 30 floors higher, to be closer to Dimon.

Drew and Macris agreed to reduce Iksil’s positions and tried to do so beginning in early 2011, according to a current and two former executives. The plan was to work down the book gradually as they found opportunities to sell the assets, these people said. The problem: No one was buying. The position was too large and illiquid and couldn’t be reduced without a loss. Drew and Macris decided the bank could hold the trades to maturity and that the risk of being forced to liquidate them under duress was low, according to the former executives.

‘Risk 101’

Early this year, as the size and volatility of its trades were growing, the bank changed the computer-based mathematical formulas for calculating the chief investment office’s VaR. The new model had the effect of understating the risk of losses from Iksil’s trades: It showed an average daily VaR within the CIO of US$67-million, about where it stood in the fourth quarter of 2011.

On May 10, when JPMorgan announced the loss, Dimon said the bank had reviewed the effectiveness of the new model, deemed it “inadequate” and decided to go back to the original model. On that basis, VaR doubled to US$129-million. So far, the bank hasn’t disclosed how or when VaR for the CIO unit was changed while the model for the rest of the firm remained untouched. Nor has it explained who sought the change and who approved it.

Unable to unwind Iksil’s bets, the bank tried to hedge them this year with other trades, exacerbating the losses, Dimon said on May 10. Iksil had amassed positions in securities linked to the financial health of corporations that were so large he was driving price moves in the US$10-trillion market.

Dimon later called it “a Risk 101 mistake.” Shares of the company have dropped 19% through Monday since the losses were announced, and at least half a dozen agencies, including the U.S. Department of Justice and the Securities and Exchange Commission, are investigating.

‘Brightest Angel’

While Dimon hasn’t faced the same public scrutiny that rivals at Goldman Sachs and Bank of America endured after the 2008 credit crunch, the attention surrounding his testimony has echoes with the bank’s own history. In 1933, after Congress was shaken by another financial crisis, J.P. “Jack” Morgan, then CEO of the company, was summoned to testify about preferential treatment that JPMorgan gave certain clients.

‘The system is more fragile today with more too-big-to-fail banks with proven incompetence at their management level’

The public reaction was “extreme disillusionment: the brightest angel on Wall Street had fallen,” Ron Chernow wrote in his 1990 book, “The House of Morgan.” The scandal “cast it in the mud with other banks.”

The embarrassing disclosures in those hearings led to the Glass-Steagall Act, which forced JPMorgan to split off its investment-banking business from its deposit-taking arm. Dimon’s testimony tomorrow may have a similar effect: Giving ammunition to those who would enforce stricter regulation of banks, including advocates of the Volcker rule, which would bar most proprietary trading by deposit-taking institutions and that the JPMorgan CEO has fought vociferously.

Psychiatrists

He has said former Fed Chairman Paul Volcker, for whom the rule is named, doesn’t understand capital markets. He quipped that bankers will need psychiatrists to evaluate whether their trades qualify as hedges. Last year he took on Fed Chairman Ben S. Bernanke in a public forum, blaming excessive regulation for slowing a U.S. economic recovery and asking whether anyone has “bothered to study the cumulative effect of all these things.”

Now, his own lapses may come back to haunt him.

“The risk management is as amateurish as you can get on Wall Street,” Nassim Taleb, a professor of risk engineering at New York University and author of “The Black Swan: The Impact of the Highly Improbable,” said in a telephone interview about the bank’s loss. “JPMorgan is vastly more fragile today than it was five years ago, and the system is more fragile today with more too-big-to-fail banks with proven incompetence at their management level.”

That’s the question regulators from the Federal Reserve to the Office of the Comptroller of the Currency are confronting after JPMorgan Chase & Co. reported a $2 billion trading loss from a credit-derivatives position Chief Executive Officer Jamie Dimon called a “hedge.”

Regulators are under pressure to respond to JPMorgan’s loss as they finish writing the so-called Volcker Rule, which restricts banks’ proprietary trading and is the most controversial provision in the Dodd-Frank Act. They’re scrutinizing the so-called hedging exemption in the proposed regulation and probably will narrow the exceptions for trades banks say are designed to mitigate risk, according to two people familiar with the matter.

JPMorgan’s loss “will reinforce the position of those who want to be tough,” Representative Barney Frank, a Massachusetts Democrat and co-author of the financial-overhaul legislation, said in a telephone interview. “I do think it will mean Volcker will not allow” such trades.

The rule, named for former Fed Chairman Paul Volcker, is intended to reduce the chance that banks will put depositors’ money at risk. Dodd-Frank, signed into law in 2010, largely left regulators to define the provisions, and in October, they released a proposal for the rule, which is scheduled to take effect in July. In April, the Fed said banks would have two years to implement it, as long as they make a “good faith” effort to comply with the ban on proprietary trading.

Under the proposed version, bankers would be permitted to do “risk-mitigating hedging activities” for “aggregate positions.” That means using derivatives or other products to reduce the risk of an entire pool of investments, as opposed to a single transaction or position.

The JPMorgan loss has ignited a debate whether aggregate or portfolio hedging is appropriate at all and how to define and spot these trades.

Frank said he hopes regulators will prevent such positions, allowing banks to hedge only against specific investments to offset potential losses.

“Aggregate hedging isn’t hedging, it’s a profit center,” he said. “They are talking about making money out of it,” when “hedges break even.”

In the wake of JPMorgan’s loss, regulators “clearly” are looking “more skeptically at the claim about portfolio hedging and what does the word ‘aggregate’ in the law mean you have to do,” said Karen Shaw Petrou, a managing partner at Federal Financial Analytics, a Washington research firm.

Wall Street has aggressively lobbied against the Volcker Rule. The five regulators implementing the provision received over 17,000 comment letters — the most for any part of the law. Bankers devoted the majority of their efforts to aspects other than hedging, such as allowances for trading by so-called market-makers who buy and sell securities to establish prices and whether banks can take positions in sovereign debt.

JPMorgan employs 12 lobbyists and spent $7.6 million on these activities in 2011, according to the Center for Responsive Politics in Washington. Dimon led Wall Street bosses in a closed-door meeting with Fed Governor Daniel Tarullo on May 2 to press the central bank to ease regulations, including the Volcker Rule.

Dimon publicly challenged Ben S. Bernanke in June 2011 on tougher oversight, asking whether the Fed chairman had “a fear like I do” that overzealous regulation “will be the reason it took so long” for banks, credit and job creation to recover from the financial crisis.

Fed spokeswoman Barbara Hagenbaugh declined to comment.

The KBW Bank Index of 24 financial stocks has dropped 14 percent since July 2010, the month Dodd-Frank was passed, compared with a 16 percent gain in the Standard & Poor’s 500 Index of stocks. JPMorgan shares have underperformed both, tumbling 21 percent to $31.93 on June 1.

Bank lobbyists now say they’re on hold in reaction to the attention JPMorgan has attracted. Their complaints may only strengthen the call for tougher rules, said Oliver Ireland, a partner at Morrison & Foerster LLP.

“The problem with this event is it doesn’t do the industry’s credibility any good, so it’s not clear the industry pushing a lot harder now would do any good,“ Ireland said. “It may create a backlash.”

Dimon, who asked regulators in a February letter to loosen up their definition of portfolio hedging, said on a May 10 call with analysts that JPMorgan’s chief investment office made “egregious mistakes” by taking flawed positions on synthetic credit. He previously pushed the unit, which oversees about $360 billion, to seek profit by speculating on higher-yielding assets, ex-employees said in April.

The positions were “done with the intention to hedge the tail risk for JPMorgan” and could result in an additional $1 billion loss or more as they’re wound down, Dimon said. “But I am telling you it morphed over time; and the new strategy, which was meant to reduce the hedge overall, made it more complex, more risky, and it was unbelievably ineffective.”

JPMorgan profited in 2011 by betting that credit conditions would worsen. Then in December, the European Central Bank provided long-term loans to euro-zone banks, igniting a bond rally and leaving JPMorgan’s bearish bets vulnerable. So the chief investment office made offsetting bullish investments using credit-default-swap indexes that are thought to expire at the end of 2017, according to market participants.

The office put on another bearish trade to protect against short-term losses using contracts due in 2012, market participants said. Losses may have mounted when prices between the two indexes became distorted because JPMorgan was such a big seller of insurance. The trader who built the credit-derivatives positions, Bruno Iksil, was nicknamed the “London whale” because the investments became so large.

The company’s investments can’t “be described in any way as a hedge,” Michael Platt, co-founder and CEO of BlueCrest Capital Management LLP, said in a May 21 interview with Bloomberg Television. “I think it’s a trading loss. They deliberately put the positions on. The London whale, who has subsequently been harpooned, put the positions on.”

Geneva-based BlueCrest manages $32 billion and took a “small” position against JPMorgan, Platt said.

U.S. Commodity Futures Trading Commission Chairman Gary Gensler and U.S. Securities & Exchange Commission Chairman Mary Schapiro both acknowledged May 22 the difficulty regulators face in allowing some risk-mitigating hedging and then trying to determine when it’s gone too far.

“The challenge when somebody uses a word like ‘portfolio hedging’ is that it can mutate and morph into many things beyond hedging specific positions,” Gensler said May 21, 10 days before the CFTC held a round-table discussion about narrowing exemptions in the Volcker Rule.

An administration official told reporters on May 22 that regulators will use the JPMorgan loss as a real-life example to inform the final rule. Regulators feel pressure to react and will scrutinize the hedging exemption, according to another person who works for an agency involved in the writing of the law who wasn’t authorized to speak publicly and declined to be identified.

More stringent regulations are sure to be unpopular with bankers. “You wouldn’t want to make a big change based on one event,” said Tim Ryan, president and CEO of the Securities Industry and Financial Markets Association, Wall Street’s main lobbying group. “This is a complicated proposal.”

Lawmakers are using JPMorgan’s loss for “political expediency,” and it’s unlikely that portfolio hedging actually will be banned, predicted Douglas Landy, a partner at Allen & Overy LLP in New York.

Banks do need the ability to mitigate risks in their portfolio using derivatives, said Ernest Patrikis, a partner at White & Case LLP.

“It’s insanity to think that they shouldn’t be doing it,” said Patrikis, former general counsel at the Federal Reserve Bank of New York. Regulators may consider options such as forcing financial institutions to “demonstrate more fully” their positions or restricting how they can hedge, he said.

The Financial Stability Oversight Council, created by Dodd- Frank and led by Treasury Secretary Timothy F. Geithner, discussed JPMorgan’s loss and the Volcker Rule at a May 22 meeting, Treasury spokesman Anthony Coley said. It’s “premature” to conclude whether the rule “would have prohibited these trades and the hedging activity” the bank conducted, Bryan Hubbard, a spokesman for the comptroller’s office, said May 14 in an e-mailed statement.

Senators Jeff Merkley, an Oregon Democrat, and Carl Levin, a Michigan Democrat, who co-wrote the Volcker provision, said JPMorgan’s trading losses underline why hedging on a portfolio basis should be barred in the final version.

“Pressure from lobbyists during the rule-making process gave rise to regulatory loopholes that would allow proprietary trading to be hidden within market-making, risk-mitigating hedging and wealth management, among other areas,” the senators said in a May 17 letter to the Fed and other regulators.

The Senate Banking Committee has begun hearings on JPMorgan and its implications for regulatory changes. The bank regulators and Neal Wolin, Treasury Department deputy secretary, will testify on June 6; Dimon will testify June 13. Dimon also will appear before the House Financial Services Committee on June 19.

The main impact of JPMorgan’s sour trades will be to speed up work on finalizing the Volcker rule, said Brian Gardner, senior vice president in Washington at investment bank Keefe Bruyette & Woods Inc.

Regulators “are under the gun to finish” in a way that is “totally unreasonable, which is to make sure there are no losses at banks,” he said. “They’ve basically been assigned mission impossible.”

‘They really made two stupid decisions. The first was taking risks with derivatives that they did not understand. The second is selling assets with high income that they can’t replace’

NEW YORK — JPMorgan Chase & Co has sold an estimated US$25 billion of profitable securities in an effort to prop up earnings after suffering trading losses tied to the bank’s now-infamous “London Whale,” compounding the cost of those trades.

CEO Jamie Dimon earlier this month said the bank sold corporate bonds and other securities, pocketing US$1 billion in gains that will help offset more than US$2 billion in losses. As a result, the bank will not have to report as big an earnings hit for the second quarter.

The sales of profitable securities from elsewhere in the bank’s investment portfolio will increase its costs by triggering taxes on the gains and by eliminating future earnings from the securities.

Related

Gains from the sales could provide about 16 cents a share of earnings, about one-fifth of the bank’s second-quarter profit, analysts said. But rather than creating new value for investors, the transactions merely shift gains in securities from one part of the company’s financial statements to another.

“They really made two stupid decisions,” said Lynn Turner, a consultant and former chief accountant of the Securities and Exchange Commission. The first was taking risks with derivatives that they did not understand, Turner said.

“The second is selling assets with high income that they can’t replace,” Turner added. In a low interest-rate environment, the bank will struggle to generate as much income with the cash it received from selling the securities, he said.

Dimon first disclosed the sales on May 10 when he announced the derivatives losses generated from the bank’s London office and trader Bruno Iksil — dubbed the “London Whale” in credit markets due to the size of the trading positions he took. Dimon noted that the bank has another US$8 billion of profit it could gain by selling an array of debt securities.

It remains unclear exactly when the bank sold the securities, and the bank has not detailed the value of securities it sold. Given the drawbacks of the sales, it also is unclear how many more the bank will sell to bolster second-quarter profits. To be sure, the bank may have additional reasons for making the sales, and the sales do not violate laws nor are they likely to hurt the bank’s stability.

A JPMorgan spokeswoman declined to comment beyond the company’s public statements.

US$380 MILLION TAX BILL

However, based on disclosures that show the bank has historically realized less than a 4% gain from selling these kinds of securities, JPMorgan would have to sell US$25 billion in securities to generate US$1 billion in gains, according to a Reuters analysis of the bank’s practices.

Taxes on the gains, if calculated at the 38% tax rate that JPMorgan uses to illustrate its business to analysts, would mean a US$380 million cost to realize the gains. That would leave a net gain to earnings of US$620 million, or 16 cents a share.

Before the sale, the gains would have existed on the bank’s books as so-called paper profits, and would have been included on its balance sheet. But when the bank sold and realized the gains, they moved to its income statement as profit.

Paul Miller, an analyst at FBR Capital Markets, said the bank should skip the asset sales and “just take the pain” of reporting lower profits.

Dimon, too, has said he is reluctant to cash in good investments. He highlighted the tax issues in selling these securities when he spoke to analysts May 10.

“We can take some of those gains and we can take them to offset this loss,” he said. “But usually it’s tax inefficient, so we’re very careful about taking gains.”

Yet the bank is under pressure to show strong profits. Its stock has fallen 18% since the day before it disclosed the losses. It closed Friday at US$33.50.

The bank currently is expected to report earnings of 90 cents a share for the second quarter, according to analysts surveyed by Thomson Reuters I/B/E/S. That compares with US$1.24 a share before the derivatives debacle was disclosed and US$1.27 a share that the bank reported a year earlier.

LOSSES COULD INCREASE

Dimon has not said who at the bank decided to sell the securities. Nor has he said if the decision was made before he knew that the derivatives losses could top US$3 billion and before he told analysts on April 13 that reports of trouble with derivatives trades were a “tempest in a teapot.”

Meanwhile, the bank’s losses could grow, which could increase pressure on the bank to continue securities sales. Some analysts have said the total losses could exceed US$5 billion, since the credit derivative markets in which the trades were made are thinly traded and current prices are not favorable to JPMorgan.

The pool from which the securities were sold included, as of March 31, corporate debt securities with an average yield of 3.15% and mortgage-backed securities yielding 3.41%, according to a company filing. Using the cash to buy back similar securities would not produce yields as high, analysts said.

The financial industry has gone through periods in the past when banks cashed out good assets to cushion losses, said former SEC Chief Accountant Turner. It happened during the U.S. savings and loan crisis in the 1980s, abated during a period of tougher regulatory scrutiny and fewer losses, and then came back during the latest financial crisis.

But the costs are significant. In statements about the latest losses, Dimon has been careful to emphasize the disadvantage of paying more taxes, said Chris Kotowski, an analyst at Oppenheimer & Co.

“I think he was trying to tell you, ’Don’t expect us to offset all of these losses,”’ Kotowski said.